We propose new methodology to estimate arbitrage portfolios by utilizing information contained in firm characteristics for both abnormal returns and factor loadings. The methodology gives maximal weight to risk-based interpretations of characteristics' predictive power before any attribution to abnormal returns. We apply the methodology in simulated factor economies and to a large panel of U.S. stock returns from 1965-2014. The methodology works well in simulation and when applied to U.S. stocks. Empirically, we find the arbitrage portfolio has (statistically and economically) significant alphas relative to several popular asset pricing models and annualized Sharpe ratios ranging from 1.35 to 1.75.

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