Working Paper

Factor Selection and Structural Breaks

Abstract: We develop a new approach to select risk factors in an asset pricing model that allows the set to change at multiple unknown break dates. Using the six factors displayed in Table 1 since 1963, we document a marked shift towards parsimonious models in the last two decades. Prior to 2005, five or six factors are selected, but just two are selected thereafter. This finding offers a simple implication for the factor zoo literature: ignoring breaks detects additional factors that are no longer relevant. Moreover, all omitted factors are priced by the selected factors in every regime. Finally, the selected factors outperform popular factor models as an investment strategy.

Keywords: Model comparison; Factor models; Structural breaks; Anomaly; Bayesian analysis; Discount factor; Portfolio analysis; Sparsity;

JEL Classification: G12; C11; C12; C52; C58;

https://doi.org/10.17016/FEDS.2024.037

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2024-05-31

Number: 2024-037