Bryzgalova, S, Pelger, M and Zhu, J (2020) Forest Through the Trees: Building Cross-Sections of Stock Returns. Working Paper. Social Sciences Research Network.
Abstract
We show how to build a cross-section of asset returns, that is, a small set of basis or test assets that capture complex information contained in a given set of stock characteristics and span the Stochastic Discount Factor (SDF). We use decision trees to generalize the concept of conventional sorting and introduce a new approach to the robust recovery of the SDF, which endogenously yields optimal portfolio splits. These low-dimensional value-weighted long-only investment strategies are well diversified, easily interpretable, and reflect many characteristics at the same time. Empirically, we show that traditionally used cross-sections of portfolios and their combinations, especially deciles and long-short anomaly factors, present too low a hurdle for model evaluation and serve as the wrong building blocks for the SDF. Constructed from the same pricing signals as conventional double or triple sorts, our cross-sections have significantly higher (up to a factor of three) out-of-sample Sharpe ratios and pricing errors relative to the leading reduced-form asset pricing models.
More Details
Item Type: | Monograph (Working Paper) |
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Subject Areas: | Finance |
Date Deposited: | 03 Nov 2020 15:39 |
Last Modified: | 21 Nov 2024 02:37 |
URI: | https://lbsresearch.london.edu/id/eprint/1531 |