Covariances, Characteristics, and General Equilibrium : A Critique

We question a deep-ingrained doctrine in asset pricing: if an empirical characteristic-return relation is consistent with investor “rationality,” the relation must be “explained” by a risk factor model. The investment approach changes the big picture of asset pricing. Factors formed on characteristics are not necessarily risk factors: characteristics-based factor models can be linear approximations of firm-level investment returns. The evidence that characteristics dominate covariances in horse races does not necessarily mean mispricing: measurement errors in covariances are likely to blame. Most important, the investment approach completes the consumption approach in general equilibrium, especially for cross-sectional asset pricing