The Factor Model Failure Puzzle

101 Pages Posted: 23 Nov 2021 Last revised: 15 Mar 2022

See all articles by Fahiz Baba Yara

Fahiz Baba Yara

Indiana University - Kelley School of Business

Brian H. Boyer

Brigham Young University - J. Willard and Alice S. Marriott School of Management

Carter Davis

Kelley School of Business, Indiana University

Date Written: November 19, 2021

Abstract

Despite the weak theoretical assumptions needed to guarantee the existence of a factor model that prices the cross-section of stock returns we show in a meta-analysis of fifteen state-of-the-art models that none of these models can price the mean-variance efficient portfolio of the other fourteen. No one model effectively describes the cross-section of US equities. Our results highlight the need to benchmark new factor models against each other, rather than anomaly portfolios or classic double sorted portfolios. When markets are incomplete, an infinite number of stochastic discount factors price assets, but empirically, we have yet to find just one. We refer to this as the factor model failure puzzle. We present a theoretical model with many weak anomaly trading signals and show that slight methodological deviations lead to different factor models that result in different and flawed characterizations of the risk-return trade-off as observed empirically.

Keywords: asset pricing, machine learning, factor models, stochastic discount factors, mean-variance efficiency, random forests, neural networks, prediction, Sharpe ratio optimization

JEL Classification: G10, G12

Suggested Citation

Baba Yara, Fahiz and Boyer, Brian H. and Davis, Carter, The Factor Model Failure Puzzle (November 19, 2021). Available at SSRN: https://ssrn.com/abstract=3967588 or http://dx.doi.org/10.2139/ssrn.3967588

Fahiz Baba Yara

Indiana University - Kelley School of Business ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

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

Brian H. Boyer

Brigham Young University - J. Willard and Alice S. Marriott School of Management ( email )

Provo, UT 84602
United States

Carter Davis (Contact Author)

Kelley School of Business, Indiana University ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

HOME PAGE: http://https://sites.google.com/site/carterkentdavis/

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