An Efficient Factor from Basis Anomalies

Abstract

A look-ahead-bias-free, ex-ante efficient portfolio from Size, B/M and Momentum anomalies has an ex-post Sharpe ratio of 2.3. The one factor drives out 39 “anomalies” from a total of 43, the remaining 4 have high turnover and trading costs. It prices 200 “anomalous” portfolios and significantly out-perform the combined 12 factors: MKT-RF, SMB, HML, MOM, LTR, STR, RMW, CMA, QMJ, ILIQ, BAB, DEV. GRS test cannot reject the factor’s ex-post efficiency. The 12%/year long-short spread from the efficient factor beta cannot be explained by all 12 factors combined, but 1 factor alone. Optimal mixture of new exotic characteristics can be engineered to pass existing testing tools as “unique anomalies”, yet are completely manifested by the efficient factor.A theory where assets are priced recursively w.r.t. the group-specific efficient factor shows that “anomalous” predictabilities are equivalent to 1-factor pricing, regardless of rational/behavioral cause. The Implied Stochastic Discount Factor return deduced from the efficient factor is consistent with economic theory, while the one from the market return is not.