Measurement of Factor Strenght: Theory and Practice

94 Pages Posted: 11 Mar 2020

See all articles by Natalia Bailey

Natalia Bailey

Monash University

George Kapetanios

King's College, London

M. Hashem Pesaran

University of Southern California - Department of Economics; University of Cambridge - Trinity College (Cambridge)

Date Written: 2020

Abstract

This paper proposes an estimator of factor strength and establishes its consistency and asymptotic distribution. The proposed estimator is based on the number of statistically significant factor loadings, taking account of the multiple testing problem. We focus on the case where the factors are observed which is of primary interest in many applications in macroeconomics and finance. We also consider using cross section averages as a proxy in the case of unobserved common factors. We face a fundamental factor identification issue when there are more than one unobserved common factors. We investigate the small sample properties of the proposed estimator by means of Monte Carlo experiments under a variety of scenarios. In general, we find that the estimator, and the associated inference, perform well. The test is conservative under the null hypothesis, but, nevertheless, has excellent power properties, especially when the factor strength is sufficiently high. Application of the proposed estimation strategy to factor models of asset returns shows that out of 146 factors recently considered in the finance literature, only the market factor is truly strong, while all other factors are at best semi-strong, with their strength varying considerably over time. Similarly, we only find evidence of semi-strong factors in an updated version of the Stock and Watson (2012) macroeconomic dataset.

Keywords: factor models, factor strength, measures of pervasiveness, cross-sectional dependence, market factor

JEL Classification: C380, E200, G200

Suggested Citation

Bailey, Natalia and Kapetanios, George and Pesaran, M. Hashem, Measurement of Factor Strenght: Theory and Practice (2020). CESifo Working Paper No. 8146, Available at SSRN: https://ssrn.com/abstract=3552386

Natalia Bailey (Contact Author)

Monash University ( email )

23 Innovation Walk
Wellington Road
Clayton, Victoria 3800
Australia

George Kapetanios

King's College, London ( email )

30 Aldwych
London, WC2B 4BG
United Kingdom
+44 20 78484951 (Phone)

M. Hashem Pesaran

University of Southern California - Department of Economics

3620 South Vermont Ave. Kaprielian (KAP) Hall 300
Los Angeles, CA 90089
United States

University of Cambridge - Trinity College (Cambridge) ( email )

United Kingdom

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