Taming the Factor Zoo: A Test of New Factors

75 Pages Posted: 20 Mar 2017 Last revised: 29 Jul 2019

See all articles by Guanhao Feng

Guanhao Feng

City University of Hong Kong (CityUHK)

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: June 29, 2019

Abstract

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 that produce a bias due to the omitted variables, unlike the standard approaches that assume perfect variable selection, which rarely occurs in practice. We apply our procedure to a set of factors recently discovered in the literature. While most of these new factors are found to be redundant relative to the existing factors, a few — such as profitability — have statistically significant explanatory power beyond the hundreds of factors proposed in the past. In addition, we show that our estimates and their significance are stable, whereas the model selected by simple LASSO is not. Finally, we provide additional applications of our procedure that illustrate how it could help control the proliferation of factors in the zoo.

Keywords: Factors, Stochastic Discount Factor, Post-Selection Inference, Regularized Two-Pass Estimation, Variable Selection, Machine Learning, LASSO, Elastic Net, PCA

Suggested Citation

Feng, Guanhao and Giglio, Stefano and Xiu, Dacheng, Taming the Factor Zoo: A Test of New Factors (June 29, 2019). Fama-Miller Working Paper; 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 (CityUHK) ( 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 )

London
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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