Abstract - Factor covariances predict factor returns

We examine low-turnover zero-investment “factor” portfolios constructed from various stock characteristics previously shown to predict returns. The nine different factor portfolios all exhibit negative market betas. Our central result is that a more negative beta across factors predicts higher factor returns over the next two years. Similarly, the average relative volatility of the factor returns as well as the cross-sectional variance of the betas and volatilities predict future factor returns. While the results are difficult to reconcile with standard risk-based explanations, they are consistent with the existence of a time-varying mass of naïve investors subject to the house-money effect, whose trading affects the returns to characteristics-based factor portfolios. Indeed, the average beta across factors is highly negatively correlated across time with the Baker and Wurgler (2006) investor sentiment measure.


Søren Hvidkjær
Copenhagen Business School
07. May. 2013

Back to overview