Informative Value, Profitability, and Investment Factors

Book-to-market, profitability, and investment - the characteristics underlying the Fama-French value, profitability, and investment factors - are imperfect indicators of expected returns. This study narrows down the characteristics' expected return information and uses their informative parts to construct enhanced factors. These informative factors exhibit around 50% higher Sharpe ratios than their standard counterparts. They strongly outperform the standard Fama-French factors regarding the maximum Sharpe ratio criterion and in pricing characteristics-sorted portfolios. Importantly, unlike the standard factors, the informative factors exhibit positive risk prices, making them genuine risk factor candidates. Moreover, our procedure to enhance the factors outperforms other enhancement procedures.