A common practice in the finance literature is to create characteristic portfolios by sorting on characteristics associated with average returns. We show that the resultant portfolios are likely to capture not only the priced risk associated with the characteristic but also unpriced risk. We develop a procedure to remove this unpriced risk using covariance information estimated from past returns. We apply our methodology to the five Fama-French characteristic portfolios. The squared Sharpe ratio of the optimal combination of the resultant characteristic-efficient portfolios is 2.13, compared with 1.17 for the original characteristic portfolios.

At least one co-author has disclosed a financial relationship of potential relevance for this research. Further information is available online at http://www.nber.org/papers/w24164.ack NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications.

Standard-Nutzungsbedingungen:Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden.Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen.Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte.

Short-sale constrained past-winners and losers both underperform strongly in the rst year post-formation, earning market-adjusted returns of −13%, and −17%, respectively. However, constrained winners continue to underperform for the following four years, earning a cumulative market-adjusted return of −40% (t = −6.31), while past-losers earn 6% (t = 0.56). This persistence dierential cannot be explained by existing models or by simple extensions of existing models. We propose a dynamic heterogeneous agents model featuring overcondence and slow information diusion, which is able to explain this asymmetry in mispricing persistence among short-sale constrained stocks, and to match value and momentum eects for unconstrained stocks.

for helpful comments as well as Zahi Ben-David, Sam Hanson and Byoung Hwang for helpful insights about the short-interest data.