59 Pages Posted: 27 Dec 2022 Last revised: 29 Jan 2023
Date Written: December 23, 2022
Firms with similar characteristics display similar expected returns. Defining neighbouring assets as those with the most similar set of characteristics, I show that past returns of an asset's neighbours predict its future expected returns. If a majority of an asset's neighbours have performed poorly (well) in the past, it is likely that this asset also performs poorly (well) in the future. By classifying each asset into a decile portfolio based on the past performance of its neighbours, with 94 characteristics, a long-short portfolio generates an out-of-sample annualized Sharpe ratio of 1.15 with a monthly alpha of 2.72% (t = 8.86).
Keywords: Asset pricing, portfolios, cross-section of expected returns, stock characteristics, machine learning
JEL Classification: G10, G11, G14, C14, C11, C21, C22, C23, C58
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