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Re-examining Equity Factor Research Replicability

March 19, 2021 • Posted in Big Ideas, Equity Premium

Several recent papers find that most studies identifying factors that predict stock returns are not replicable or derive from snooping of many factors. Is there a good counter-argument? In their January 2021 paper entitled “Is There a Replication Crisis in Finance?”, Theis Ingerslev Jensen, Bryan Kelly and Lasse Pedersen apply a Bayesian model of factor replication to a set of 153 factors applied to stocks across 93 countries. For each factor in each country, they each month:

  1. Sort stocks into thirds (top/middle/bottom) with breakpoints based on non-micro stocks in that country.
  2. For each third, compute a “capped value weight” gross return (winsorizing market equity at the NYSE 80th percentile to ensure that tiny stocks have tiny weights no mega-stock dominates).
  3. Calculate the gross return for a hedge portfolio that is long (short) the third with the highest (lowest) expected return.
  4. Calculate the corresponding 1-factor gross alpha via simple regression versus the country portfolio.

They further propose a taxonomy that systematically assigns each of the 153 factors to one of 13 themes based on high within-theme return correlations and conceptual similarities. Using firm and stock data required to calculate the specified factors starting 1926 for U.S. stocks and 1986 for most developed countries (in U.S. dollars), and 1-month U.S. Treasury bill yields to compute excess returns, all through 2019, they find that: (more…)

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