Characteristic-based factors and market return

Abstract

We provide the first comprehensive study of examining the predictive power of characteristic-based
factors on market excess return. We find that characteristic-based factors negatively predict market
excess return regardless of whether they are originated from investment, mispricing or behavioral
models. The negative predictability exists both in-sample and out-of-sample and emonstrates strong economic value from the perspective of asset allocation. Both the long legs and short legs of the characteristic-based factors positively predict the market return, with short legs showing stronger predictability. Exploring different market states, the predictability of characteristics-based factors is stronger in recessions. Finally, the predictability of characteristic-based factors on market return also holds internationally.

Keywords: Equity risk premium, Characteristic-based factors, Predictive regression, Out-of-sample analysis

JEL Classification: C58, G11, G12