Industry Positions in Characteristic Factors: Risk Without Return

Characteristic-sorted factors hold an industry position as a by-product of the sort. This position accounts on average for 18 percent of an equal-weighted factor’s variance but earns 0.3 percent a year, against 5.4 percent for its within-industry part. For most signals the industry level reflects technology and accounting conventions rather than priced risk, and the signal’s industry clustering shows the position before any return is observed. Ranking stocks within their industry removes the position with no hedge to estimate, and estimated hedges do no better. This raises the maximum Sharpe ratio of the factor zoo in every twenty-year window since 1930, by 14 percent on the 100 factors observed since 1963, and out of sample from 2.34 to 2.99.