Stock Characteristics and Stock Returns: A Skeptic’s Look at the Cross-Section of Returns

Abstract

The correlation between stock characteristics and the cross-section of stock returns plays a central role in empirical implementations of modern asset pricing models and has important implications for investment management. This remains true whether the correlation is due to investor preferences regarding the characteristics directly or whether the characteristics are proxies for state variables the risk of which investors are attempting to hedge. This paper asks what do we know about the relation between these characteristics and the cross-section of returns? The skeptic’s answer is not much. A combination of lack of persistence in the characteristics along with problems caused by model uncertainty, data snooping, and nonstationarity means that our knowledge is sketchy at best. Investors should be forewarned when considering any strategies such as smart beta that are premised on the correlation between characteristics and the cross-section of returns.