Abstract
This study uses the Bayesian approach to examine the incremental contribution of stock characteristics to the investment opportunity set in U.K. stock returns. The paper finds that size, book-to-market (BM) ratio, and momentum characteristics all make a significant incremental contribution to the investment opportunity set when there is unrestricted short selling. However, no short selling constraints eliminate the incremental contribution of the size and BM characteristics, but not the momentum characteristic. The use of additional stock characteristics such as stock issues, accruals, profitability, and asset growth leads to a significant incremental contribution beyond the size, BM, and momentum characteristics when there is unrestricted short selling, but no short selling constraints largely eliminates the incremental contribution of the additional characteristics.
Highlights
There is a long history that stock characteristics have a significant predictive ability of cross-sectional expected excess stock returns
This paper examines the incremental contribution of stock characteristics on the investment opportunity set in UK stock returns in the presence of no short selling constraints following a similar approach to Fama and French (2015)
I formally test whether there is a significant shift in the investment opportunity set from adding the quintile portfolios to the benchmark investment universe to see if the additional stock characteristics make a significant incremental contribution to the investment opportunity set
Summary
There is a long history that stock characteristics have a significant predictive ability of cross-sectional expected excess stock returns. The three most prominent characteristics have been size (Banz 1981), book-to-market (BM) ratio (Fama and French 1992), and momentum (Jegadeesh and Titman 1993). A recent study by Chordia, Goyal and Shanken (Chordia et al 2015) examine the relative contributions of both betas and stock characteristics in explaining the cross-sectional variation in expected excess returns. Chordia et al find that stock characteristics make the dominant contribution to explaining cross-sectional variation in expected excess returns. During the past two decades, a number of studies have identified additional stock characteristics that predict cross-sectional stock returns. Liu and Zhu (Harvey et al 2016) document 314 variables that prior research has found to predict stock returns (Green et al 2017)
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