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Taming the Factor Zoo

69 Pages Posted: 20 Mar 2017 Last revised: 8 Sep 2017

Guanhao Feng

City University of Hong Kong - College of Business

Stefano Giglio

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Dacheng Xiu

University of Chicago - Booth School of Business

Date Written: August 31, 2017

Abstract

The asset pricing literature has produced hundreds of potential risk factors. Organizing this “zoo of factors" and distinguishing between useful, useless, and redundant factors require econometric techniques that can deal with the curse of dimensionality. We propose a model-selection method to systematically evaluate the contribution to asset pricing of any new factor, above and beyond what a high-dimensional set of existing factors explains. Our methodology explicitly accounts for potential model-selection mistakes, unlike the standard approaches that assume perfect variable selection, which rarely occurs in finite sample and produces a bias due to the omitted variables. We apply our procedure to a set of factors recently discovered in the literature. We show that several factors - such as profitability and investments - have statistically significant explanatory power beyond the hundreds of factors proposed in the past. In addition, we show that our risk price estimates and their significance are stable, whereas the model selected by simple LASSO is not.

Keywords: Factors, Risk Price, Post-Selection Inference, Regularized Two-Pass Estimation, Machine Learning, LASSO, Elastic Net

Suggested Citation

Feng, Guanhao and Giglio, Stefano and Xiu, Dacheng, Taming the Factor Zoo (August 31, 2017). Fama-Miller Working Paper Forthcoming; Chicago Booth Research Paper No. 17-04. Available at SSRN: https://ssrn.com/abstract=2934020 or http://dx.doi.org/10.2139/ssrn.2934020

Guanhao Feng

City University of Hong Kong - College of Business ( email )

83 Tat Chee Avenue
Kowloon Tong
Hong Kong

Stefano Giglio

Yale School of Management ( email )

135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Centre for Economic Policy Research (CEPR) ( email )

77 Bastwick Street
London, EC1V 3PZ
United Kingdom

Dacheng Xiu (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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