Principal Portfolios

72 Pages Posted: 22 Jun 2020 Last revised: 1 Nov 2024

See all articles by Bryan T. Kelly

Bryan T. Kelly

Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)

Semyon Malamud

Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

Lasse Heje Pedersen

AQR Capital Management, LLC; Copenhagen Business School - Department of Finance; Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: June 2020

Abstract

We propose a new asset-pricing framework in which all securities’ signals are used to predict each individual return. While the literature focuses on each security’s own-signal predictability, assuming an equal strength across securities, our framework is flexible and includes cross-predictability—leading to three main results. First, we derive the optimal strategy in closed form. It consists of eigenvectors of a “prediction matrix,” which we call “principal portfolios.” Second, we decompose the problem into alpha and beta, yielding optimal strategies with, respectively, zero and positive factor exposure. Third, we provide a new test of asset pricing models. Empirically, principal portfolios deliver significant out-of-sample alphas to standard factors in several data sets.

Suggested Citation

Kelly, Bryan T. and Malamud, Semyon and Pedersen, Lasse Heje, Principal Portfolios (June 2020). NBER Working Paper No. w27388, Available at SSRN: https://ssrn.com/abstract=3632614

Bryan T. Kelly (Contact Author)

Yale SOM ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Semyon Malamud

Ecole Polytechnique Federale de Lausanne ( email )

Lausanne, 1015
Switzerland

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Lasse Heje Pedersen

AQR Capital Management, LLC ( email )

Greenwich, CT
United States

Copenhagen Business School - Department of Finance ( email )

Solbjerg Plads 3
Frederiksberg, DK-2000
Denmark

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

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