The Cross-Section of Risk and Return
In the nance literature, a common practice is to create characteristic portfolios by sorting on characteristics associated with average returns. We show that the resulting portfolios are likely to capture not only the priced risk associated with the characteristic, but also unpriced risk. We develop a procedure to remove this unpriced risk using covariance information estimated from past returns. We apply our methodology to the ve Fama and French (2015) characteristic portfolios. The squared Sharpe ratio of the optimal combination of the resulting characteristic efficient portfolios is 2.16, compared with 1.16 for the original characteristic portfolios.
Daniel, Kent, Lira Mota, Simon Rottke, and Tano Santos. "The Cross-Section of Risk and Return." Columbia Business School, November 4, 2019.
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