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Stock Characteristics and Stock Returns: A Skeptic’s Look at the Cross Section of Expected Returns

Bradford Cornell
The Journal of Portfolio Management July 2020, jpm.2020.1.154; DOI: https://doi.org/10.3905/jpm.2020.1.154
Bradford Cornell
is an emeritus professor of finance at the Anderson Graduate School of Management at UCLA and a senior advisor to the Cornell Capital Group in La Canada, CA
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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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Stock Characteristics and Stock Returns: A Skeptic’s Look at the Cross Section of Expected Returns
Bradford Cornell
The Journal of Portfolio Management May 2020, jpm.2020.1.154; DOI: 10.3905/jpm.2020.1.154

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Stock Characteristics and Stock Returns: A Skeptic’s Look at the Cross Section of Expected Returns
Bradford Cornell
The Journal of Portfolio Management May 2020, jpm.2020.1.154; DOI: 10.3905/jpm.2020.1.154
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  • Article
    • Abstract
    • EARLY DEVELOPMENTS
    • CHARACTERISTICS AND THE CROSS SECTION OF RETURNS
    • FACTOR RISK AND THE CROSS SECTION OF AVERAGE RETURNS
    • FORECASTING RETURN PREMIUMS BASED ON STOCK CHARACTERISTICS
    • CONCLUSION
    • ACKNOWLEDGMENTS
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