Integrating Factor Models

Abstract

This paper develops a comprehensive framework to address uncertainty about the correct factor model. Asset pricing inferences draw on a composite model that integrates over competing factor models weighted by posterior probabilities. Evidence shows that unconditional models record zero probabilities, and post-earnings announcement drift, quality-minus-junk, and intermediary capital are incremental factors in conditional asset pricing. The integrated model tilts away from the subsequently underperforming factors, and delivers stable and admissible strategies. Model uncertainty makes equities appear considerably riskier, while model disagreement about expected returns spikes during crash episodes. Disagreement spans all return components involving mispricing, factor loadings, and risk premia.

Publication
The Journal of Finance (2023), 78, 1593-1646

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