Winners from Winners: A Tale of Risk Factors

Abstract

Starting from the twelve distinct factors from Fama and French (1993, 2015, 2018), Hou, Xue, and Zhang (2015), Stambaugh and Yuan (2017), and Daniel, Hirshleifer, and Sun (2020), plus twelve principal components of anomalies unexplained by the initial factors, a Bayesian comparison of approximately 17 million models in terms of marginal likelihoods and posterior model probabilities shows that {Mkt, MOM, IA, ROE, MGMT, PERF, PEAD, FIN} plus the nonconsecutive principal components, {PC1, PC5, PC7} are the best supported risk-factors. Pricing tests and annualized out-of-sample Sharpe ratios for tangency portfolios suggest that this asset pricing model should be used for computing expected returns, assessing investment strategies and building portfolios.

Keywords: Model comparison, Factor models, Anomaly, Discount factor, Portfolio analysis

JEL Classification: G12, C11, C12, C52, C58