No Sparsity in Asset Pricing: Evidence from a Generic Statistical Test

55 Pages Posted: 26 Mar 2024

See all articles by Junnan He

Junnan He

Sciences Po

Lingxiao Zhao

Peking University HSBC Business School

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: February 18, 2024

Abstract

We present a novel test to determine sparsity in characteristic-based factor models. Applying the test to industry and pseudo-random portfolios, we reject the null hypothesis that fewer than ten factors are sufficient to explain returns, and show that at least forty factors are needed for the various sample periods examined. We find that dense models outperform sparse ones in both pricing and investing. Testing with tree-based portfolios also indicates no sparsity. Our results suggest that most existing factor models, which have fewer than six factors, are questionable, and that future research on such low-dimensional models is unlikely to be fruitful.

Keywords: JEL Classification: G12, C12 factor models, characteristic-based factors, sparsity, test

JEL Classification: G12, C12

Suggested Citation

He, Junnan and Zhao, Lingxiao and Zhou, Guofu, No Sparsity in Asset Pricing: Evidence from a Generic Statistical Test (February 18, 2024). Available at SSRN: https://ssrn.com/abstract=4730259 or http://dx.doi.org/10.2139/ssrn.4730259

Junnan He

Sciences Po ( email )

28 Rue des Saints-Pères
Paris, 75007
France

Lingxiao Zhao (Contact Author)

Peking University HSBC Business School

Peking University HSBC Business School (PHBS)
University Town, Nanshan District
Shenzhen
China

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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