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Rev Fin 2000; 13:883-916
© 2000 the Society for Financial Studies

Article

Asset pricing models: implications for expected returns and portfolio selection

A Craig MacKinlay1,z and L Pástor2
1 The Wharton School, 3620 Locust Walk, Philadelphia, PA 19104-6367, USA
2 University of Chicago, Chicago, IL, USA
z Corresponding author
E-mail: acmack@wharton.upenn.edu

Abstract

When a risk factor is missing from an asset pricing model, the resulting mispricing is embedded within the residual covariance matrix. Exploiting this phenomenon leads to expected return estimates that are more stable and precise than estimates delivered by standard methods. Portfolio selection can also be improved. At an extreme, optimal portfolio weights are proportional to expected returns when no factors are observable. We find that such portfolios perform well in simulations and in out-of-sample comparisons.


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