Efficient Factor Selection: Explaining Risk and Mean Returns Jointly

62 Pages Posted: 20 Apr 2018

See all articles by Ronald J. Balvers

Ronald J. Balvers

McMaster University - Michael G. DeGroote School of Business

Adam Stivers

University of Wisconsin - La Crosse

Date Written: April 4, 2018

Abstract

An asset pricing model is customarily evaluated by how well it explains means of returns. But how well the model explains fluctuations of returns is similarly important though often overlooked in the literature. We derive “efficient” factors that combine both objectives and turn out to maximize average time-series (first-pass) R-square for given cross-sectional (second-pass) R-square. Efficient factors work better out of sample and even explain mean returns better than structural models. The reason is that structural models emphasize factors that as a group are close to the tangency portfolio. But this portfolio, by necessity, has relatively low variance that explains individual asset return fluctuations poorly and impedes factor identification. These findings explain many of the puzzling results in empirical asset pricing. Further, intended holding period becomes essential now for model evaluation and shorter holding periods require more emphasis on first-pass fit, which is another key issue overlooked in the literature.

Keywords: asset pricing, arbitrage pricing, factor analysis, hedging, risk management, model selection

JEL Classification: G12, G17, G11, C38

Suggested Citation

Balvers, Ronald J. and Stivers, Adam, Efficient Factor Selection: Explaining Risk and Mean Returns Jointly (April 4, 2018). Available at SSRN: https://ssrn.com/abstract=3156699 or http://dx.doi.org/10.2139/ssrn.3156699

Ronald J. Balvers (Contact Author)

McMaster University - Michael G. DeGroote School of Business ( email )

1280 Main Street West
Hamilton, Ontario L8S 4M4
Canada
(905) 525-9140 x23969 (Phone)

HOME PAGE: http://profs.degroote.mcmaster.ca/business/balvers

Adam Stivers

University of Wisconsin - La Crosse ( email )

1725 State Street
La Crosse, WI 54601
United States
608-785-6677 (Phone)

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