Compressing the Equity Factor Zoo

The number of published factors significantly explaining variation in individual stock returns has grown steadily over time into the hundreds, inviting the term "factor zoo." Are all these factors important when applied in combination? In their October 2023 paper entitled "Factor Zoo", Alexander Swade, Matthias Hanauer, Harald Lohre and David Blitz assess compressibility of the factor zoo by starting with the market factor and then adding one-at-a-time via iterative regressions the factor explaining the largest amount of residual (unexplained) alpha, until the incremental alpha explained by adding a factor is no longer significant. For each factor in their main analysis, they each month calculate its return by: (1) sorting stocks based on the factor; (2) forming a portfolio that is long (short) the third of stocks with the the highest (lowest) expected returns; and, (3) holding the portfolio for one month. They weight stocks in these portfolios based on market valuation capped at the 80th percentile of NYSE valuations (but consider simple value-weighted and equal-weighted portfolios in robustness tests). Using monthly returns for 153 known U.S. equity factors during November 1971 through December 2021, they find that: