Shrinking Factor Dimension: A Reduced-Rank Approach

48 Pages Posted: 23 Jul 2018 Last revised: 21 Mar 2022

See all articles by Ai He

Ai He

University of South Carolina - Darla Moore School of Business

Dashan Huang

Singapore Management University - Lee Kong Chian School of Business

Jiaen Li

Washington University in St. Louis - John M. Olin Business School

Guofu Zhou

Washington University in St. Louis - John M. Olin Business School

Date Written: December 17, 2019

Abstract

We provide a reduced-rank approach (RRA) to extract a few factors from a large set of factor proxies, and apply the extracted factors to model the cross section of expected stock returns. Empirically, we find that the RRA five-factor model outperforms the well known Fama-French five-factor model as well as the corresponding PCA, PLS and LASSO models for pricing portfolios. However, at the stock level, our RRA factor model still has large pricing errors even after adding more factors, suggesting that the representative factor proxies of our study do not have sufficient information for pricing individual stocks.

Keywords: reduced rank, PCA, PLS, factors, factor model, cross section

JEL Classification: G1, G11, G12, G17

Suggested Citation

He, Ai and Huang, Dashan and Li, Jiaen and Zhou, Guofu, Shrinking Factor Dimension: A Reduced-Rank Approach (December 17, 2019). Available at SSRN: https://ssrn.com/abstract=3205697 or http://dx.doi.org/10.2139/ssrn.3205697

Ai He

University of South Carolina - Darla Moore School of Business ( email )

1014 Greene Street
Columbia, SC 29208
United States

HOME PAGE: http://www.aihefinance.com/

Dashan Huang

Singapore Management University - Lee Kong Chian School of Business ( email )

50 Stamford Road
Singapore, 178899
Singapore

HOME PAGE: http://dashanhuang.weebly.com/

Jiaen Li

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1208
Saint Louis, MO MO 63130-4899
United States

Guofu Zhou (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

Washington University
Campus Box 1133
St. Louis, MO 63130-4899
United States
314-935-6384 (Phone)
314-658-6359 (Fax)

HOME PAGE: http://apps.olin.wustl.edu/faculty/zhou/

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