Basis Portfolios

Abstract

I propose creating a small set of well-diversified high-dimensional basis portfolios such that stocks within (across) portfolios have the most (least) similar fundamentals, proxied by a large set of characteristics. If the comovement between stocks is a function of a large set of characteristics, the high-dimensional basis portfolios that are distinct in all characteristics show low comovements and high dispersion in expected returns. As a result, the optimal portfolio spanned by high-dimensional basis portfolios displays a sizeable out-of-sample Sharpe ratio of 1.78 with a monthly alpha of 1.71% (t = 11.11), without taking any extreme position on any asset.

Keywords: Asset pricing, mean-variance efficient portfolio, stock characteristics, covariance matrix, optimal weights, high-dimensional portfolio sort

JEL Classification: C10, G11