Are Characteristics Covariances? A Comment on Instrumented Principal Component Analysis

43 Pages Posted: 23 Jun 2020

See all articles by Christian Fieberg

Christian Fieberg

University of Bremen

Lars Hornuf

University of Bremen - Faculty of Business Studies and Economics; Max Planck Institute for Innovation and Competition; CESifo (Center for Economic Studies and Ifo Institute)

Gerrit Liedtke

University of Bremen

Thorsten Poddig

University of Bremen

Date Written: 2020

Abstract

We present analytical and simulation-based evidence that instrumented principal component analysis (IPCA) cannot reliably distinguish between whether covariances or characteristics explain asset returns because the question has to be answered jointly with the question of how many factors have to be modeled. IPCA finds a covariance-based explanation when estimating too many factors (“alpha-eating”) and a characteristic-based explanation when estimating too few factors (“beta-eating”). Our results therefore call into question the empirical evidence recently obtained that stocks (Kelly et al., 2019), options (Büchner and Kelly, 2022), and bonds (Kelly et al., 2021) are explained by covariances.

Keywords: cross-section of stock returns, covariances, characteristics, IPCA

JEL Classification: C230, G110, G120

Suggested Citation

Fieberg, Christian and Hornuf, Lars and Liedtke, Gerrit and Poddig, Thorsten, Are Characteristics Covariances? A Comment on Instrumented Principal Component Analysis (2020). CESifo Working Paper No. 8377, Available at SSRN: https://ssrn.com/abstract=3633662 or http://dx.doi.org/10.2139/ssrn.3633662

Christian Fieberg

University of Bremen ( email )

Max-von-Laue-Straße 1
Bremen, DE Bremen D-28359
Germany

HOME PAGE: http://www.fiwi.uni-bremen.de

Lars Hornuf (Contact Author)

University of Bremen - Faculty of Business Studies and Economics ( email )

Bremen, D-28359
Germany
+49 89 20348619 (Phone)

HOME PAGE: http://www.hornuf.com

Max Planck Institute for Innovation and Competition ( email )

Marstallplatz 1
Munich, Bayern 80539
Germany

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

Gerrit Liedtke

University of Bremen ( email )

Thorsten Poddig

University of Bremen ( email )

Universitaetsallee GW I
Bremen, D-28334
Germany

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