ABSTRACT Moreira and Muir question the existence of a strong risk‐return trade‐off by showing that investors can improve performance by reducing exposure to risk factors when their volatility is high. However, Cederburg et al. show that these strategies fail out‐of‐sample, and Barroso and Detzel show they do not survive transaction costs. We propose a conditional multifactor portfolio that outperforms its unconditional counterpart even out‐of‐sample and net of costs. Moreover, we show that factor risk prices generally decrease with market volatility. Our results demonstrate that the breakdown of the risk‐return trade‐off is more puzzling than previously thought.

We propose a formal statistical test to compare asset-pricing models in the presence of price impact. In contrast to the case without trading costs, we show that in the presence of price-impact costs different models may be best at spanning the investment opportunities of different investors depending on their absolute risk aversion. Empirically, we find that the five-factor model of Hou et al. (2021), the six-factor model of Fama and French (2018) with cash-based operating profitability, and a high-dimensional model are best at spanning the investment opportunities of investors with high, medium, and low absolute risk aversion, respectively.