Measurement of factor strength: theory and practice

Natalia Bailey, George Kapetanios, M. Hashem Pesaran

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1 Citation (Scopus)

Abstract

This paper proposes an estimator of factor strength and establishes its consistency and asymptotic distribution. The estimator is based on the number of statistically significant factor loadings, taking multiple testing into account. Both cases of observed and unobserved factors are considered. The small sample properties of the proposed estimator are investigated using Monte Carlo experiments. It is shown that the proposed estimation and inference procedures perform well and have excellent power properties, especially when the factor strength is sufficiently high. Empirical applications to factor models for asset returns show that out of 146 factors recently considered in the finance literature, only the market factor is truly strong, while all other factors are at best semi-strong, with their strength varying considerably over time. Similarly, we only find evidence of semi-strong factors using a large number of US macroeconomic indicators.

Original languageEnglish
Pages (from-to)587-613
Number of pages27
JournalJournal of Applied Econometrics
Volume36
Issue number5
DOIs
Publication statusPublished - Aug 2021

Keywords

  • cross-sectional dependence
  • factor models
  • factor strength
  • macroeconomic shocks
  • market factor
  • measures of pervasiveness

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