Time Series Variation in the Factor Zoo

Abstract

The ability of three- to six-factor models to explain the cross-section of stock returns varies substantially over time, providing scope for time-varying numbers of additional factors. We show that additional factors are relevant and non-redundant, as out-of-sample Sharpe ratios formed from principal components of factors identified in-sample are economically substantive and continue to increase up to more than twenty factor principal components. The numbers of significant factors are strongly related to variation in economic conditions and measures of diversity in firm characteristics. These results suggest that time variation in the number of significant factors reflects time-varying economic complexity.

Keywords: Asset Pricing, Factors, Complexity, Time series variation, Diversity

JEL Classification: G10, G11, G12