Characteristic-Based Returns: Alpha or Smart Beta?
Journal of Investment Management, 20 (First Quarter 2022):70-89.
32 Pages Posted: 24 Jul 2021 Last revised: 20 Jan 2022
Date Written: December 16, 2021
Abstract We propose new methodology to construct arbitrage portfolios by utilizing information contained in firm characteristics for both abnormal returns and betas (and, therefore, smart-beta risk premiums). Our methodology gives maximal weight to risk-based interpretations of characteristics' predictive power before any attribution to abnormal returns. The method allows the explanatory power of a characteristic for both alpha and beta to ebb and flow. This feature is particularly important when we expect that profit opportunities may be arbitraged away by investors. We apply the methodology to a large panel of U.S. stock returns from 1965–2018. Empirically, characteristics have time-varying explanatory power for both factor betas and alpha. We find the arbitrage portfolio has (statistically and economically) significant alpha and annualized Sharpe ratios ranging from 1.31 to 1.66.
Keywords: arbitrage, characteristic based model, smart beta, factor pricing
JEL Classification: G12, C58, C38
Suggested Citation: Suggested Citation