IDEAS home Printed from https://ideas.repec.org/a/eee/jimfin/v136y2023ics0261560623000669.html
   My bibliography  Save this article

Which factor model? A systematic return covariation perspective

Author

Listed:
  • Ahmed, Shamim
  • Bu, Ziwen
  • Symeonidis, Lazaros
  • Tsvetanov, Daniel

Abstract

We examine which factor model best captures systematic return covariation by focusing on the economic implications for portfolio risk control. The pairwise variance equality test and the model confidence set procedure suggest that the Fama and French (2015) five-factor model, the Barillas and Shanken (2018) six-factor model, and the Fama and French (2018) six-factor model are the top performers for the factor model-implied minimum risk portfolios in the out-of-sample. When it comes to the minimum tracking error portfolios, the Barillas and Shanken (2018) six-factor model and the Fama and French (2018) six-factor model are the overall winners in the horse race.

Suggested Citation

  • Ahmed, Shamim & Bu, Ziwen & Symeonidis, Lazaros & Tsvetanov, Daniel, 2023. "Which factor model? A systematic return covariation perspective," Journal of International Money and Finance, Elsevier, vol. 136(C).
    • Handle: RePEc:eee:jimfin:v:136:y:2023:i:c:s0261560623000669
    DOI: 10.1016/j.jimonfin.2023.102865
    as

    Download full text from publisher

    File URL: http://www.sciencedirect.com/science/article/pii/S0261560623000669
    Download Restriction: Full text for ScienceDirect subscribers only
    File URL: https://libkey.io/10.1016/j.jimonfin.2023.102865?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    As the access to this document is restricted, you may want to search for a different version of it.

    References listed on IDEAS

    as
    1. Ang, Andrew & Liu, Jun & Schwarz, Krista, 2020. "Using Stocks or Portfolios in Tests of Factor Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 55(3), pages 709-750, May.
    2. Sébastien Laurent & Jeroen V. K. Rombouts & Francesco Violante, 2012. "On the forecasting accuracy of multivariate GARCH models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 27(6), pages 934-955, September.
    3. Gospodinov, Nikolay & Kan, Raymond & Robotti, Cesare, 2013. "Chi-squared tests for evaluation and comparison of asset pricing models," Journal of Econometrics, Elsevier, vol. 173(1), pages 108-125.
    4. Tim Bollerslev & Benjamin Hood & John Huss & Lasse Heje Pedersen, 2018. "Risk Everywhere: Modeling and Managing Volatility," Review of Financial Studies, Society for Financial Studies, vol. 31(7), pages 2729-2773.
    5. Victor DeMiguel & Lorenzo Garlappi & Raman Uppal, 2009. "Optimal Versus Naive Diversification: How Inefficient is the 1-N Portfolio Strategy?," Review of Financial Studies, Society for Financial Studies, vol. 22(5), pages 1915-1953, May.
    6. Guanhao Feng & Stefano Giglio & Dacheng Xiu, 2020. "Taming the Factor Zoo: A Test of New Factors," Journal of Finance, American Finance Association, vol. 75(3), pages 1327-1370, June.
    7. Olivier Ledoit & Michael Wolf, 2017. "Nonlinear Shrinkage of the Covariance Matrix for Portfolio Selection: Markowitz Meets Goldilocks," Review of Financial Studies, Society for Financial Studies, vol. 30(12), pages 4349-4388.
    8. Louis K.C. Chan & Jason Karceski & Josef Lakonishok, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," NBER Working Papers 7039, National Bureau of Economic Research, Inc.
    9. Barillas, Francisco & Kan, Raymond & Robotti, Cesare & Shanken, Jay, 2020. "Model Comparison with Sharpe Ratios," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 55(6), pages 1840-1874, September.
    10. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1683, August.
    11. Aguilar, Omar & West, Mike, 2000. "Bayesian Dynamic Factor Models and Portfolio Allocation," Journal of Business & Economic Statistics, American Statistical Association, vol. 18(3), pages 338-357, July.
    12. Peter R. Hansen & Asger Lunde & James M. Nason, 2011. "The Model Confidence Set," Econometrica, Econometric Society, vol. 79(2), pages 453-497, March.
    13. K. J. Martijn Cremers & Antti Petajisto, 2009. "How Active Is Your Fund Manager? A New Measure That Predicts Performance," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3329-3365, September.
    14. Lewellen, Jonathan & Nagel, Stefan & Shanken, Jay, 2010. "A skeptical appraisal of asset pricing tests," Journal of Financial Economics, Elsevier, vol. 96(2), pages 175-194, May.
    15. Michael W. Brandt & Pedro Santa-Clara & Rossen Valkanov, 2009. "Parametric Portfolio Policies: Exploiting Characteristics in the Cross-Section of Equity Returns," Review of Financial Studies, Society for Financial Studies, vol. 22(9), pages 3411-3447, September.
    16. Pastor, Lubos & Stambaugh, Robert F., 2003. "Liquidity Risk and Expected Stock Returns," Journal of Political Economy, University of Chicago Press, vol. 111(3), pages 642-685, June.
    17. Francisco Barillas & Jay Shanken, 2018. "Comparing Asset Pricing Models," Journal of Finance, American Finance Association, vol. 73(2), pages 715-754, April.
    18. Martijn Cremers & Antti Petajisto, 2006. "How Active is Your Fund Manager? A New Measure That Predicts Performance," Yale School of Management Working Papers amz2370, Yale School of Management, revised 01 May 2009.
    19. Victor DeMiguel & Francisco J. Nogales & Raman Uppal, 2014. "Stock Return Serial Dependence and Out-of-Sample Portfolio Performance," Review of Financial Studies, Society for Financial Studies, vol. 27(4), pages 1031-1073.
    20. Foster, F Douglas & Smith, Tom & Whaley, Robert E, 1997. "Assessing Goodness-of-Fit of Asset Pricing Models: The Distribution of the Maximal R-Squared," Journal of Finance, American Finance Association, vol. 52(2), pages 591-607, June.
    21. Peter Reinhard Hansen & Asger Lunde & James M. Nason, 2003. "Choosing the Best Volatility Models: The Model Confidence Set Approach," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 65(s1), pages 839-861, December.
    22. Robert F. Engle & Kevin Sheppard, 2001. "Theoretical and Empirical properties of Dynamic Conditional Correlation Multivariate GARCH," NBER Working Papers 8554, National Bureau of Economic Research, Inc.
    23. Kewei Hou & Chen Xue & Lu Zhang, 2015. "Editor's Choice Digesting Anomalies: An Investment Approach," Review of Financial Studies, Society for Financial Studies, vol. 28(3), pages 650-705.
    24. Kuntara Pukthuanthong & Richard Roll & Avanidhar Subrahmanyam, 2019. "A Protocol for Factor Identification," Review of Financial Studies, Society for Financial Studies, vol. 32(4), pages 1573-1607.
    25. Fama, Eugene F. & French, Kenneth R., 2015. "A five-factor asset pricing model," Journal of Financial Economics, Elsevier, vol. 116(1), pages 1-22.
    26. Miguel A. Ferreira, 2005. "Evaluating Interest Rate Covariance Models Within a Value-at-Risk Framework," Journal of Financial Econometrics, Oxford University Press, vol. 3(1), pages 126-168.
    27. Asger Lunde & Peter R. Hansen, 2005. "A forecast comparison of volatility models: does anything beat a GARCH(1,1)?," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 20(7), pages 873-889.
    28. Liu, Lily Y. & Patton, Andrew J. & Sheppard, Kevin, 2015. "Does anything beat 5-minute RV? A comparison of realized measures across multiple asset classes," Journal of Econometrics, Elsevier, vol. 187(1), pages 293-311.
    29. Ledoit, Oliver & Wolf, Michael, 2008. "Robust performance hypothesis testing with the Sharpe ratio," Journal of Empirical Finance, Elsevier, vol. 15(5), pages 850-859, December.
    30. Chan, Louis K. C. & Karceski, Jason & Lakonishok, Josef, 1998. "The Risk and Return from Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 33(2), pages 159-188, June.
    31. Kent Daniel & David Hirshleifer & Lin Sun, 2020. "Short- and Long-Horizon Behavioral Factors [Financial intermediaries and the cross-section of asset returns]," Review of Financial Studies, Society for Financial Studies, vol. 33(4), pages 1673-1736.
    32. Chamberlain, Gary, 1983. "Funds, Factors, and Diversification in Arbitrage Pricing Models," Econometrica, Econometric Society, vol. 51(5), pages 1305-1323, September.
    33. Engle, Robert F. & Ng, Victor K. & Rothschild, Michael, 1990. "Asset pricing with a factor-arch covariance structure : Empirical estimates for treasury bills," Journal of Econometrics, Elsevier, vol. 45(1-2), pages 213-237.
    34. David Hirshleifer & Po-Hsuan Hsu & Dongmei Li, 2018. "Innovative Originality, Profitability, and Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 31(7), pages 2553-2605.
    35. Robert F. Engle & Olivier Ledoit & Michael Wolf, 2019. "Large Dynamic Covariance Matrices," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 37(2), pages 363-375, April.
    36. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
    37. Ang, Andrew, 2014. "Asset Management: A Systematic Approach to Factor Investing," OUP Catalogue, Oxford University Press, number 9780199959327, Decembrie.
    38. Pastor, Lubos & Stambaugh, Robert F., 2000. "Comparing asset pricing models: an investment perspective," Journal of Financial Economics, Elsevier, vol. 56(3), pages 335-381, June.
    39. Ravi Jagannathan & Tongshu Ma, 2003. "Risk Reduction in Large Portfolios: Why Imposing the Wrong Constraints Helps," Journal of Finance, American Finance Association, vol. 58(4), pages 1651-1684, August.
    40. Gianluca De Nard & Olivier Ledoit & Michael Wolf, 2021. "Factor Models for Portfolio Selection in Large Dimensions: The Good, the Better and the Ugly [Using Principal Component Analysis to Estimate a High Dimensional Factor Model with High-frequency Data," Journal of Financial Econometrics, Oxford University Press, vol. 19(2), pages 236-257.
    41. Tobias J. Moskowitz, 2003. "An Analysis of Covariance Risk and Pricing Anomalies," Review of Financial Studies, Society for Financial Studies, vol. 16(2), pages 417-457.
    42. Juhani T Linnainmaa & Michael R Roberts, 2018. "The History of the Cross-Section of Stock Returns," Review of Financial Studies, Society for Financial Studies, vol. 31(7), pages 2606-2649.
    43. Connor, Gregory & Korajczyk, Robert A, 1993. "A Test for the Number of Factors in an Approximate Factor Model," Journal of Finance, American Finance Association, vol. 48(4), pages 1263-1291, September.
    44. Nardari, Federico & Scruggs, John T., 2007. "Bayesian Analysis of Linear Factor Models with Latent Factors, Multivariate Stochastic Volatility, and APT Pricing Restrictions," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 42(4), pages 857-891, December.
    45. Lo, Andrew W & MacKinlay, A Craig, 1990. "Data-Snooping Biases in Tests of Financial Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 3(3), pages 431-467.
    46. Carhart, Mark M, 1997. "On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    47. Engle, Robert & Colacito, Riccardo, 2006. "Testing and Valuing Dynamic Correlations for Asset Allocation," Journal of Business & Economic Statistics, American Statistical Association, vol. 24, pages 238-253, April.
    48. Martijn Cremers & Antti Petajisto, 2006. "How Active is Your Fund Manager? A New Measure That Predicts Performance," Yale School of Management Working Papers amz2370, Yale School of Management, revised 01 May 2009.
    49. Kent Daniel & David Hirshleifer & Lin Sun, 2020. "Short- and Long-Horizon Behavioral Factors," Review of Finance, European Finance Association, vol. 33(4), pages 1673-1736.
    50. Engle, Robert, 2002. "Dynamic Conditional Correlation: A Simple Class of Multivariate Generalized Autoregressive Conditional Heteroskedasticity Models," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(3), pages 339-350, July.
    51. Simin, Timothy, 2008. "The Poor Predictive Performance of Asset Pricing Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 43(2), pages 355-380, June.
    52. Olivier Ledoit & Michael Wolf & Zhao Zhao, 2019. "Efficient Sorting: A More Powerful Test for Cross-Sectional Anomalies," Journal of Financial Econometrics, Oxford University Press, vol. 17(4), pages 645-686.
    53. Stefano Giglio & Dacheng Xiu, 2021. "Asset Pricing with Omitted Factors," Journal of Political Economy, University of Chicago Press, vol. 129(7), pages 1947-1990.
    54. Fama, Eugene F. & French, Kenneth R., 1993. "Common risk factors in the returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 33(1), pages 3-56, February.
    55. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    56. Eugene F. Fama & Kenneth R. French, 2016. "Dissecting Anomalies with a Five-Factor Model," Review of Financial Studies, Society for Financial Studies, vol. 29(1), pages 69-103.
    57. Chan, Louis K C & Karceski, Jason & Lakonishok, Josef, 1999. "On Portfolio Optimization: Forecasting Covariances and Choosing the Risk Model," Review of Financial Studies, Society for Financial Studies, vol. 12(5), pages 937-974.
    58. Ahmed, Shamim & Bu, Ziwen & Tsvetanov, Daniel, 2019. "Best of the Best: A Comparison of Factor Models," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 54(4), pages 1713-1758, August.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Hansen, Erwin, 2022. "Economic evaluation of asset pricing models under predictability," Journal of Empirical Finance, Elsevier, vol. 68(C), pages 50-66.
    2. Thomas Conlon & John Cotter & Iason Kynigakis, 2021. "Machine Learning and Factor-Based Portfolio Optimization," Papers 2107.13866, arXiv.org.
    3. Chiang, I-Hsuan Ethan & Liao, Yin & Zhou, Qing, 2021. "Modeling the cross-section of stock returns using sensible models in a model pool," Journal of Empirical Finance, Elsevier, vol. 60(C), pages 56-73.
    4. Massimo Guidolin & Erwin Hansen & Martín Lozano-Banda, 2018. "Portfolio performance of linear SDF models: an out-of-sample assessment," Quantitative Finance, Taylor & Francis Journals, vol. 18(8), pages 1425-1436, August.
    5. Adam Zaremba & Jacob Koby Shemer, 2018. "Price-Based Investment Strategies," Springer Books, Springer, number 978-3-319-91530-2, November.
    6. Santos, André A.P. & Moura, Guilherme V., 2014. "Dynamic factor multivariate GARCH model," Computational Statistics & Data Analysis, Elsevier, vol. 76(C), pages 606-617.
    7. Johannes Bock, 2018. "An updated review of (sub-)optimal diversification models," Papers 1811.08255, arXiv.org.
    8. Söhnke M. Bartram & Harald Lohre & Peter F. Pope & Ananthalakshmi Ranganathan, 2021. "Navigating the factor zoo around the world: an institutional investor perspective," Journal of Business Economics, Springer, vol. 91(5), pages 655-703, July.
    9. Ma, Xiuli & Zhang, Xindong & Liu, Weimin, 2021. "Further tests of asset pricing models: Liquidity risk matters," Economic Modelling, Elsevier, vol. 95(C), pages 255-273.
    10. Huber, Daniel & Jacobs, Heiko & Müller, Sebastian & Preissler, Fabian, 2023. "International factor models," Journal of Banking & Finance, Elsevier, vol. 150(C).
    11. Caldeira, João F & Moura, Guilherme Valle & Santos, André Alves Portela, 2013. "Seleção de carteiras utilizando o modelo Fama-French-Carhart," Revista Brasileira de Economia - RBE, EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil), vol. 67(1), April.
    12. De Nard, Gianluca & Engle, Robert F. & Ledoit, Olivier & Wolf, Michael, 2022. "Large dynamic covariance matrices: Enhancements based on intraday data," Journal of Banking & Finance, Elsevier, vol. 138(C).
    13. De Nard, Gianluca & Zhao, Zhao, 2023. "Using, taming or avoiding the factor zoo? A double-shrinkage estimator for covariance matrices," Journal of Empirical Finance, Elsevier, vol. 72(C), pages 23-35.
    14. Stadtmüller, Immo & Auer, Benjamin R. & Schuhmacher, Frank, 2022. "On the benefits of active stock selection strategies for diversified investors," The Quarterly Review of Economics and Finance, Elsevier, vol. 85(C), pages 342-354.
    15. Behr, Patrick & Guettler, Andre & Truebenbach, Fabian, 2012. "Using industry momentum to improve portfolio performance," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1414-1423.
    16. repec:fgv:epgrbe:v:67:n:1:a:3 is not listed on IDEAS
    17. Fletcher, Jonathan, 2018. "Bayesian tests of global factor models," Journal of Empirical Finance, Elsevier, vol. 48(C), pages 279-289.
    18. Christoffersen, Peter & Langlois, Hugues, 2013. "The Joint Dynamics of Equity Market Factors," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 48(5), pages 1371-1404, October.
    19. Caporin, Massimiliano & McAleer, Michael, 2014. "Robust ranking of multivariate GARCH models by problem dimension," Computational Statistics & Data Analysis, Elsevier, vol. 76(C), pages 172-185.
    20. Gregory Connor & Lisa R. Goldberg & Robert A. Korajczyk, 2010. "Portfolio Risk Analysis," Economics Books, Princeton University Press, edition 1, number 9224.
    21. Hoang, Khoa & Cannavan, Damien & Gaunt, Clive & Huang, Ronghong, 2019. "Is that factor just lucky? Australian evidence," Pacific-Basin Finance Journal, Elsevier, vol. 57(C).

    More about this item

    Keywords

    Asset pricing model; Factor model; Model evaluation; Portfolio selection; Out-of-sample;
    All these keywords.

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:eee:jimfin:v:136:y:2023:i:c:s0261560623000669. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Catherine Liu (email available below). General contact details of provider: http://www.elsevier.com/locate/inca/30443 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.