A Dynamic Model of Characteristic-Based Return Predictability

Abstract

We present a dynamic model that links characteristic-based return predictability to systematic factors that determine the evolution of firm fundamentals. In the model, an economy-wide disruption process reallocates profits from existing businesses to new projects and thus generates a source of systematic risk for portfolios of firms sorted on value, profitability, and asset growth. If investors are overconfident about their ability to evaluate the disruption climate, these characteristic-sorted portfolios exhibit persistent mispricing. The model generates predictions about the conditional predictability of characteristic-sorted portfolio returns and illustrates how return persistence increases the likelihood of observing characteristic-based anomalies.