Are Characteristics Covariances? A Comment on Instrumented Principal Component Analysis

Christian Fieberg, Lars Hornuf, Gerrit Liedtke and Thorsten Poddig

No 8377, CESifo Working Paper Series from CESifo

Abstract: We present analytical and simulation-based evidence that instrumented principal component analysis (IPCA) cannot reliably distinguish between whether covariances or characteristics explain asset returns because the question has to be answered jointly with the question of how many factors have to be modeled. IPCA finds a covariance-based explanation when estimating too many factors (“alpha-eating”) and a characteristic-based explanation when estimating too few factors (“beta-eating”). Our results therefore call into question the empirical evidence recently obtained that stocks (Kelly et al., 2019), options (Büchner and Kelly, 2022), and bonds (Kelly et al., 2021) are explained by covariances.

Keywords: IPCA; covariances; characteristics; cross section of asset returns (search for similar items in EconPapers)
JEL-codes: C23 G12 G17 (search for similar items in EconPapers)
Date: 2020
New Economics Papers: this item is included in nep-ore and nep-rmg
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