Asset Pricing with Panel Tree under Global Split Criteria

60 Pages Posted: 27 Oct 2021 Last revised: 15 Sep 2022

See all articles by Lin William Cong

Lin William Cong

Cornell University - Samuel Curtis Johnson Graduate School of Management; National Bureau of Economic Research (NBER)

Guanhao Feng

City University of Hong Kong (CityU)

Jingyu He

City University of Hong Kong (CityU)

Xin He

Hunan University - College of Finance and Statistics; City University of Hong Kong (CityU)

Date Written: April 15, 2022

Abstract

We introduce a class of interpretable tree-based models (P-Tree) for analyzing (unbalanced) panel data, with iterative and global (instead of recursive and local) split criteria. We apply P-Tree to split the cross section of asset returns under the no-arbitrage condition, generating a stochastic discount factor model and diversified test portfolios for asset pricing. P-Tree visualizes nonlinear feature interactions, accommodates time-series splits, and allows interactions between macroeconomic states and asset characteristics. In an empirical study of U.S. equities, data-driven P-Tree reveals that long-term reversal, volume volatility, and industry-adjusted market equity interact to drive cross-sectional return variation, and that inflation constitutes the most critical regime-switching when interacting with firm characteristics. P-Tree models consistently outperform known observable and latent factor models at pricing individual asset and portfolio returns, while delivering profitable and transparent trading strategies utilizing characteristic interactions. Notably, the efficient portfolio on P-Tree factors generates a monthly risk-adjusted alpha of 2.46% and an annualized Sharpe ratio of 1.71 out of sample. The methodology is broadly applicable in building trees with vectorized outcomes and economic restrictions as split criteria to guard against overfitting and improve model performance.

Keywords: CART, Cross-Sectional Returns, Interpretable AI, Latent Factor, Machine Learning.

JEL Classification: C1, G11, G12

Suggested Citation

Cong, Lin and Feng, Guanhao and He, Jingyu and He, Xin, Asset Pricing with Panel Tree under Global Split Criteria (April 15, 2022). Available at SSRN: https://ssrn.com/abstract=3949463 or http://dx.doi.org/10.2139/ssrn.3949463

Lin Cong

Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )

Ithaca, NY 14853
United States

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

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Guanhao Feng (Contact Author)

City University of Hong Kong (CityU) ( email )

83 Tat Chee Avenue
Kowloon Tong
Hong Kong

Jingyu He

City University of Hong Kong (CityU) ( email )

83 Tat Chee Avenue
Hong Kong
Hong Kong

Xin He

Hunan University - College of Finance and Statistics ( email )

109th Shijiachong Road, Yuelu District
Changsha, Hunan 410006
China

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

City University of Hong Kong (CityU) ( email )

83 Tat Chee Avenue
Kowloon
Hong Kong

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