Uncommon Factors and Asset Heterogeneity in the Cross Section and Time Series

55 Pages Posted: 29 Sep 2022 Last revised: 26 Jun 2023

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)

Junye Li

Fudan University - School of Management

Date Written: June 26, 2023

Abstract

We introduce the Bayesian Clustering Model (BCM), a new general framework combining decision tree and Bayesian variable selection for modeling panel data with grouped heterogeneity, with an emphasis on economic guidance and interpretability. We apply BCM to estimating uncommon-factor models for data-driven yet economically motivated asset clusters and macroeconomic regimes, utilizing marginal likelihood to address parameter/model uncertainties and overfitting in tree growth. We find strong evidence for (i) cross-sectional heterogeneity linked to (nonlinear interactions of) idiosyncratic volatility, size, and value, and (ii) structural changes in factor relevance predicted (i.e., macro-instrumented) by market volatility and valuation. We identify MKTRF and SMB as common factors, together with multiple uncommon factors across characteristics-managed, market-timed clusters. The learned grouped heterogeneity also helps explain volatility- or size-related anomalies, offers effective test assets, and renders many popular factors irrelevant (thus mitigating the ``factor zoo'' problem). Overall, BCM outperforms benchmark common-factor models, e.g., achieving an out-of-sample cross-sectional R2 exceeding 25% for multiple clusters and an investment Sharpe ratio tripling that of the tangency portfolios built from Fama-French double-sorted portfolios.

Keywords: Decision Tree, Bayesian Spike-and-Slab, Factor Selection, Heterogeneity, Structural Breaks.

JEL Classification: C11, C38, G11, G12.

Suggested Citation

Cong, Lin and Feng, Guanhao and He, Jingyu and Li, Junye, Uncommon Factors and Asset Heterogeneity in the Cross Section and Time Series (June 26, 2023). Available at SSRN: https://ssrn.com/abstract=4219905 or http://dx.doi.org/10.2139/ssrn.4219905

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

City University of Hong Kong (CityU) ( email )

83 Tat Chee Avenue
Hong Kong

Jingyu He (Contact Author)

City University of Hong Kong (CityU) ( email )

83 Tat Chee Avenue
Hong Kong
Hong Kong

Junye Li

Fudan University - School of Management ( email )

No. 670, Guoshun Road
No.670 Guoshun Road
Shanghai, 200433
China

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