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Forest through the Trees: Building Cross‐Sections of Stock Returns

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  • SVETLANA BRYZGALOVA
  • MARKUS PELGER
  • JASON ZHU

Abstract

We build cross‐sections of asset returns for a given set of characteristics, that is, managed portfolios serving as test assets, as well as building blocks for tradable risk factors. We use decision trees to endogenously group similar stocks together by selecting optimal portfolio splits to span the stochastic discount factor, projected on individual stocks. Our portfolios are interpretable and well diversified, reflecting many characteristics and their interactions. Compared to combinations of dozens (even hundreds) of single/double sorts, as well as machine‐learning prediction‐based portfolios, our cross‐sections are low‐dimensional yet have up to three times higher out‐of‐sample Sharpe ratios and alphas.

Suggested Citation

  • Svetlana Bryzgalova & Markus Pelger & Jason Zhu, 2025. "Forest through the Trees: Building Cross‐Sections of Stock Returns," Journal of Finance, American Finance Association, vol. 80(5), pages 2447-2506, October.
    • Handle: RePEc:bla:jfinan:v:80:y:2025:i:5:p:2447-2506
    DOI: 10.1111/jofi.13477
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