Factors that Fit the Time Series and Cross-Section of Stock Returns

Martin Lettau and Markus Pelger

No 13049, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We propose a new method for estimating latent asset pricing factors that fit the timeseries and cross-section of expected returns. Our estimator generalizes Principal Component Analysis (PCA) by including a penalty on the pricing error in expected returns. We show that our estimator strongly dominates PCA and finds weak factors with high Sharpe-ratios that PCA cannot detect. Studying a large number of characteristic sorted portfolios we find that five latent factors with economic meaning explain well the cross-section and time-series of returns. We show that out-of-sample the maximum Sharpe-ratio of our five factors is more than twice as large as with PCA with significantly smaller pricing errors. Our factors are based on only a subset of the stock characteristics implying that a significant amount of characteristic information is redundant.

Keywords: Cross section of returns; Anomalies; Expected returns; High-dimensional data; Latent factors; Weak factors; Pca (search for similar items in EconPapers)
JEL-codes: C14 C52 C58 G12 (search for similar items in EconPapers)
Date: 2018-07
New Economics Papers: this item is included in nep-ecm, nep-ets, nep-fmk and nep-ore
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

Downloads: (external link)
https://cepr.org/publications/DP13049 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Journal Article: Factors That Fit the Time Series and Cross-Section of Stock Returns (2020)
Working Paper: Factors that Fit the Time Series and Cross-Section of Stock Returns (2018)
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:cpr:ceprdp:13049

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP13049

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().