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Are Characteristics Covariances? A Comment on Instrumented Principal Component Analysis

Author

Listed:
  • Christian Fieberg
  • Lars Hornuf
  • Gerrit Liedtke
  • Thorsten Poddig

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.

Suggested Citation

  • Christian Fieberg & Lars Hornuf & Gerrit Liedtke & Thorsten Poddig, 2020. "Are Characteristics Covariances? A Comment on Instrumented Principal Component Analysis," CESifo Working Paper Series 8377, CESifo.
    • Handle: RePEc:ces:ceswps:_8377
    as

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    References listed on IDEAS

    as
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    More about this item

    Keywords

    IPCA; covariances; characteristics; cross section of asset returns;
    All these keywords.

    JEL classification:

    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation

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