Sparse Modeling Under Grouped Heterogeneity with an Application to Asset Pricing

49 Pages Posted: 24 Jul 2023 Last revised: 12 May 2024

See all articles by Lin William Cong

Lin William Cong

Cornell University - Samuel Curtis Johnson Graduate School of Management; Cornell SC Johnson College of Business; 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

Multiple version iconThere are 2 versions of this paper

Date Written: July 2023

Abstract

Sparse models, though long preferred and pursued by social scientists, can be ineffective or unstable relative to large models, for example, in economic predictions (Giannone et al., 2021). To achieve sparsity for economic interpretation while exploiting big data for superior empirical performance, we introduce a general framework that jointly clusters observations (via new decision trees) and locally selects variables (with Bayesian priors) for modeling panel data with potential grouped heterogeneity. We derive analytical marginal likelihoods as global split criteria in our Bayesian Clustering Model (BCM), to incorporate economic guidance, address parameter and model uncertainties, and prevent overfitting. We apply BCM to asset pricing and estimate uncommon-factor models for data-driven asset clusters and macroeconomic regimes. We find (i) cross-sectional heterogeneity linked to (non-linear interactions of) return volatility, size, and value, (ii) structural changes in factor relevance predicted by market volatility and valuation, and (iii) MKTRF and SMB as common factors and multiple uncommon factors across characteristics-managed-market-timed clusters. BCM helps explain volatility- or size-related anomalies, exploit within-group tests, and mitigate the “factor zoo” problem. Overall, BCM outperforms benchmark common-factor models in pricing and investments in U.S. equities, e.g., attaining out-of-sample cross-sectional R2s exceeding 25% for multiple clusters and Sharpe ratio of tangency portfolios tripling built from ME-B/M 5 × 5 portfolios.

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Suggested Citation

Cong, Lin and Feng, Guanhao and He, Jingyu and Li, Junye, Sparse Modeling Under Grouped Heterogeneity with an Application to Asset Pricing (July 2023). NBER Working Paper No. w31424, Available at SSRN: https://ssrn.com/abstract=4519210

Lin Cong (Contact Author)

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

Ithaca, NY 14853
United States

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

Cornell SC Johnson College of Business ( email )

Ithaca, NY 14850
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Guanhao Feng

City University of Hong Kong (CityU) ( email )

Hong Kong

Jingyu He

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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