Long-Run Return-Risk Trade-Off of Industry Portfolios and Performance of Maximum Diversification Strategy

Abstract

Capital mobility may equalize investment opportunities across industries and cause the return-risk trade-offs of industry portfolios to converge. We show that over a long sample period, value-weighted industry portfolios have Sharpe ratios statistically indistinguishable from each other. We further show that industry Sharpe ratios exhibit mean-reversion that can be attributed to cross-industry capital mobility. An investment strategy explicitly based on equalized industry Sharpe ratios significantly outperforms the market. Its performance cannot be explained by the traditional empirical asset pricing models but is readily explained by the q-factor model. Our findings suggest that capital mobility and investment-based asset pricing have important implications on the long-run return-risk tradeoff in the financial market.