Principal portfolios

AutorS. Malamud, B. T. Kelly, L. H. Pedersen
JournalJournal of Finance
Datum9. Jan. 2023
KategorieAcademic Publications
Volume78(1)
Seitenzahlen347–387

We propose a new asset pricing framework in which all securities' signals predict each individual return. While the literature focuses on securities' own-signal predictability, assuming equal strength across securities, our framework 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.