Principal Portfolios

Bryan T. Kelly, Semyon Malamud, Lasse Heje Pedersen*

*Corresponding author for this work

Research output: Contribution to journalJournal articleResearchpeer-review

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Abstract

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.
Original languageEnglish
JournalJournal of Finance
Volume78
Issue number1
Pages (from-to)347-387
Number of pages41
ISSN0022-1082
DOIs
Publication statusPublished - Feb 2023

Bibliographical note

Published online: 14 December 2022.

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