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Abstract
The correlation between stock characteristics and the cross section of stock returns plays a central role in empirical implementations of modern asset pricing models and has important implications for investment management. This remains true whether the correlation is due to investor preferences regarding the characteristics directly or whether the characteristics are proxies for state variables, the risk of which investors are attempting to hedge. This article asks what we know about the relation between these characteristics and the cross section of returns. The skeptic’s answer is, not much. A combination of lack of persistence in the characteristics and problems caused by model uncertainty, data snooping, and nonstationarity means that our knowledge is sketchy at best. Investors should be forewarned when considering any strategies such as smart beta that are premised on the correlation between characteristics and the cross section of returns.
TOPICS: Portfolio management/multi-asset allocation, performance measurement
Key Findings
• Many investment strategies, including smart beta, are premised on the existence of predictable correlations between stock characteristics and expected returns.
• The skeptic’s view is that those correlations are not predictable owing to a combination of lack of persistence, model uncertainty, data snooping, and nonstationarity.
• Empirical results and a review of the published literature offer support for the skeptic’s view and serves as a warning for investors.
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US and Overseas: +1 646-931-9045
UK: 0207 139 1600