Seemingly Virtuous Complexity in Return Prediction

Stefan Nagel

No 34104, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Return prediction with Random Fourier Features (RFF)—a very large number, P , of nonlinear trans-formations of a small number, K, of predictor variables—has become popular recently. Surprisingly, this approach appears to yield a successful out-of-sample stock market index timing strategy even when trained in rolling windows as small as T = 12 months with P in the thousands. However, when P ≫ T , the RFF-based forecast becomes a weighted average of the T training sample returns, with weights determined by the similarity between the predictor vectors in the training data and the current predictor vector. In short training windows, similarity primarily reflects temporal proximity, so the forecast reduces to a recency-weighted average of the T return observations in the training data—essentially a momentum strategy. Moreover, because similarity declines with predictor volatility, the result is a volatility-timed momentum strategy. The strong performance of the RFF-based strategy thus stems not from its ability to extract predictive signals from the training data, but from the fact that a volatility-timed momentum strategy happened to perform well in historical data. This point becomes clear when applying the same method to artificial data in which returns exhibit reversals rather than momentum: the RFF approach still constructs the same volatility-timed momentum strategy, which then performs poorly.

JEL-codes: G12 G14 G17 (search for similar items in EconPapers)
Date: 2025-08
New Economics Papers: this item is included in nep-for
Note: AP
References: Add references at CitEc
Citations:

Downloads: (external link)
http://www.nber.org/papers/w34104.pdf (application/pdf)
Access to the full text is generally limited to series subscribers, however if the top level domain of the client browser is in a developing country or transition economy free access is provided. More information about subscriptions and free access is available at http://www.nber.org/wwphelp.html. Free access is also available to older working papers.

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:nbr:nberwo:34104

Ordering information: This working paper can be ordered from
http://www.nber.org/papers/w34104
The price is Paper copy available by mail.

Access Statistics for this paper

More papers in NBER Working Papers from National Bureau of Economic Research, Inc National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.. Contact information at EDIRC.
Bibliographic data for series maintained by ().