Principal Portfolios

Bryan T. Kelly, Semyon Malamud and Lasse Pedersen
Additional contact information
Bryan T. Kelly: Yale SOM; AQR Capital Management, LLC; National Bureau of Economic Research (NBER)
Semyon Malamud: Ecole Polytechnique Federale de Lausanne; Centre for Economic Policy Research (CEPR); Swiss Finance Institute

No 20-67, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We propose a new asset-pricing framework in which all securities’ signals are used to predict each individual return. While the literature focuses on each security’s own- signal predictability, assuming an equal strength across securities, our framework is flexible and includes cross-predictability—leading to three main results. First, we derive the optimal strategy in closed form. It consists of eigenvectors of a “prediction matrix,” which we call “principal portfolios.” Second, we decompose the problem into alpha and beta, yielding optimal strategies with, respectively, zero and positive factor exposure. Third, we provide a new test of asset pricing models. Empirically, principal portfolios deliver significant out-of-sample alphas to standard factors in several data sets.

Keywords: Portfolio choice; asset pricing tests; optimization; expected returns; predictability (search for similar items in EconPapers)
JEL-codes: C3 C58 C61 G11 G12 G14 (search for similar items in EconPapers)
Pages: 73 pages
Date: 2020-08
New Economics Papers: this item is included in nep-ore
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Related works:
Working Paper: Principal Portfolios (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2067

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