U.S. stock portfolios sorted on size; momentum; transaction costs; market-to-book, investment-to-assets, and return-on-assets (ROA) ratios; and industry classification show considerable levels and variation of return predictability, inconsistent with asset pricing models. This means that a predictable risk premium is not equal to compensation for systematic risk as implied by asset pricing theory. We show that introducing market frictions relaxes these asset pricing moments from a strict equality to a range. Empirically, it is not short sales constraints but transaction costs (below 35 basis points) that help to reconcile the observed predictability with linear portfolio return-based factor models, and partly with the durable consumption model. Across the sorts, predictability in industry returns can be reconciled with all models considered with only a 25 basis point transaction cost, whereas for momentum and ROA portfolios, up to 115 basis points are needed.

asset pricing tests, cross-sectional predictability, market frictions, time-series predictability
dx.doi.org/10.1287/mnsc.1120.1522, hdl.handle.net/1765/37442
ERIM Top-Core Articles
Management Science
Erasmus Research Institute of Management

de Roon, F.A, & Szymanowska, M.K. (2012). Asset Pricing Restrictions on Predictability: Frictions Matter. Management Science, 58(10), 1916–1932. doi:10.1287/mnsc.1120.1522