The Risk-Return Tradeoff Among Equity Factors

We examine the time-series risk-return trade-off among several long-short equity factors by estimating univariate predictive regressions of monthly factor returns onto the lagged realized variances. We obtain a positive trade-off for alternative versions of the profitability and investment factors employed in the literature. Such relationship is robust to the presence of the realized covariance (with the market factor) in the forecasting regressions, which represents consistency with Merton's ICAPM. Critically, we obtain an insignificant risk-return relationship for the market factor. The factor risk-return trade-off tends to be weaker among most international equity markets. The out-of-sample forecasting power (of factor variances for own future returns) tends to be economically significant for the investment and profitability factors. Overall, our results suggest that the time-series risk-return trade-off is substantially stronger within segments of the stock market than for the whole.