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Factor correlation and the cross section of asset returns: A correlation-robust machine learning approach

Sun, C. ORCID: 0000-0003-4081-2815 (2024). Factor correlation and the cross section of asset returns: A correlation-robust machine learning approach. Journal of Empirical Finance, 77, article number 101497. doi: 10.1016/j.jempfin.2024.101497


This paper investigates high-dimensional factor models for cross-sectional asset returns, with a specific focus on robust estimation in the presence of (highly) correlated factors. Factor correlations can significantly compromise the robustness and credibility of commonly employed analytical methods. To address this, we utilize the stochastic discount factor (SDF) and integrate it with a recently developed Machine Learning methodology (Figueiredo and Nowak, 2016). This novel approach allows us to select factors while accounting for factor correlations and to disentangle correlated factors without imposing rigid assumptions. Our empirical findings consistently highlight the paramount role of the ‘market’ factor in driving cross-sectional asset returns. In contrast, other benchmarks, including the LASSO, the Elastic-Net, and the Fama–MacBeth regression, are adversely impacted by factor correlations, rendering the ‘market’ factor redundant. Additionally, our findings underscore the importance of ‘profitability’, ‘momentum’, and ‘liquidity’-related factors in driving cross-sectional asset returns.

Publication Type: Article
Additional Information: © 2024. This manuscript version is made available under the CC-BY-NC-ND 4.0 license in new tab/window)
Publisher Keywords: Factor investing, LASSO, Firm characteristics, Stochastic discount factor, Factor zoo
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HG Finance
Departments: Bayes Business School
Bayes Business School > Finance
SWORD Depositor:
[thumbnail of Factor_correlation_and_CS_of_asset_returns.pdf] Text - Accepted Version
This document is not freely accessible until 19 September 2025 due to copyright restrictions.
Available under License Creative Commons Attribution Non-commercial No Derivatives.

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