High-Dimensional Factor Models and the Factor Zoo

Martin Lettau

No 31719, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper proposes a new approach to the “factor zoo” conundrum. Instead of applying dimension-reduction methods to a large set of portfolio returns obtained from sorts on characteristics, I construct factors that summarize the information in characteristics across assets and then sort assets into portfolios according to these “characteristic factors”. I estimate the model on a data set of mutual fund characteristics. Since the data set is 3-dimensional (characteristics of funds over time), characteristic factors are based on a tensor factor model (TFM) that is a generalization of 2-dimensional PCA. I find that parsimonious TFM captures over 90% of the variation in the data set. Pricing factors derived from the TFM have high Sharpe ratios and capture the cross-section of fund returns better than standard benchmark models.

JEL-codes: C38 G0 G12 (search for similar items in EconPapers)
Date: 2023-09
New Economics Papers: this item is included in nep-ets and nep-ger
Note: AP
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