What Matters When? Time-Varying Sparsity in Expected Returns

64 Pages Posted: 20 Aug 2019 Last revised: 12 Dec 2019

See all articles by Daniele Bianchi

Daniele Bianchi

School of Economics and Finance, Queen Mary University of London

Matthias Büchner

University of Warwick - Finance Group

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick

Date Written: August 17, 2019

Abstract

We provide a measure of sparsity for expected returns within the context of classical factor models. Our measure is inversely related to the percentage of active predictors. Empirically, sparsity varies over time and displays an apparent countercyclical behavior. Proxies for financial conditions and for liquidity supply are key determinants of the variability in sparsity. Deteriorating financial conditions and illiquid times are associated with an increase in the number of characteristics that are useful to predict anomaly returns (i.e., the forecasting model becomes more dense). Looking at specific categories of characteristics, we find that variables classified as value, trading frictions and, in particular, profitability are robustly present throughout the sample. A strategy that exploits the dynamics of sparsity to time factors delivers substantial economic gain out-of-sample relative to both a random walk and a simple rolling window shrinkage estimator as well as standard models based on preselected, well-know characteristics like size, momentum, book-to-market, investment and accruals.

Keywords: Sparsity, Returns Predictability, Cross Section of Returns, Anomalies, Asset Pricing

JEL Classification: C38, C45, C53, E43, G12, G17

Suggested Citation

Bianchi, Daniele and Büchner, Matthias and Tamoni, Andrea, What Matters When? Time-Varying Sparsity in Expected Returns (August 17, 2019). Available at SSRN: https://ssrn.com/abstract=3438754 or http://dx.doi.org/10.2139/ssrn.3438754

Daniele Bianchi (Contact Author)

School of Economics and Finance, Queen Mary University of London ( email )

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London, London E1 4NS
United Kingdom

HOME PAGE: http://whitesphd.com

Matthias Büchner

University of Warwick - Finance Group ( email )

Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain

HOME PAGE: http://mbuechner.com

Andrea Tamoni

Rutgers, The State University of New Jersey - Rutgers Business School at Newark & New Brunswick ( email )

1 Washington Park
Newark, NJ 07102
United States

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