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    The Three Types of Factor Models: A Comparison of Their Explanatory Power


    Connor, Gregory (1995) The Three Types of Factor Models: A Comparison of Their Explanatory Power. Financial Analysts Journal, 50. pp. 42-46. ISSN 0015-198X

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    Abstract

    With some blurring at the boundaries, multifactor models of asset returns can be divided into three types: macroeconomic, statistical, and fundamental. Our empirical findings confirm the conventional wisdom that statistical factor models and fundamental factor models outperform macroeconomic factor models in tenns of explanatory power. The findings also indicate that the fundamental factor model slightly outperforms the statistical factor model. This result is at first surprising, because statistical factor models are estimated by maximizing explanatory power. So, how can an alternative outperform them by this criterion? The explanation lies in the much larger number of external data sources used in fundamental factor models, particularly the large set of industry dummies. Another empirical finding is that the marginal explanatory power of a macroeconomic factor model is zero when it is added to the fundamental factor model. This result may indicate that the fundamental factors {in some unknown combination) capture the same risk characteristics as the macroeconomic factors.

    Item Type: Article
    Keywords: Factor Models; Comparison; Explanatory; Power;
    Academic Unit: Faculty of Social Sciences > Economics, Finance and Accounting
    Item ID: 8436
    Depositing User: Gregory Connor
    Date Deposited: 11 Jul 2017 16:32
    Journal or Publication Title: Financial Analysts Journal
    Publisher: CFA Institute
    Refereed: Yes
    URI:

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