Are Characteristics Covariances or Characteristics?

28 Pages Posted: 23 Jun 2020

See all articles by Lars Hornuf

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)

Christian Fieberg

University of Bremen - Department of Business Administration

Date Written: 2020

Abstract

In this article, we shed more light on the covariances versus characteristics debate by investigating the explanatory power of the instrumented principal component analysis (IPCA), recently proposed by Kelly et al. (2019). They conclude that characteristics are covariances because there is no residual return predictability from characteristics above and beyond that in factor loadings. Our findings indicate that there is no residual return predictability from factor loadings above and beyond that in characteristics either. In particular, we find that stock returns are best explained by characteristics (characteristics are characteristics) and that a one-factor IPCA model is sufficient to explain stock risk (characteristics are covariances). We therefore conclude that characteristics are covariances or characteristics, depending on whether the goal is to explain stock returns or risk.

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

JEL Classification: C230, G110, G120

Suggested Citation

Hornuf, Lars and Fieberg, Christian, Are Characteristics Covariances or Characteristics? (2020). CESifo Working Paper No. 8377, Available at SSRN: https://ssrn.com/abstract=3633662

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

Christian Fieberg

University of Bremen - Department of Business Administration ( email )

Bremen, D-28359
Germany

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

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