Estimating The Anomaly Base Rate

Abstract

The academic literature literally contains hundreds of variables that seem to predict the crosssection of expected returns. This so-called "anomaly zoo" has caused many to question whether researchers are using the right tests of statistical significance. But, here's the thing: even if researchers use the right tests, they will still draw the wrong conclusions from their econometric analyses if they start out with the wrong priors---i.e., if they start out with incorrect beliefs about the ex ante probability of encountering a tradable anomaly.So, what are the right priors? What is the correct anomaly base rate?We develop a first way to estimate the anomaly base rate by combining two key insights: 1) Empirical-Bayes methods capture the implicit process by which researchers form priors based on their past experience with other variables in the anomaly zoo. 2) Under certain conditions, there is a one-to-one mapping between these prior beliefs and the best-fit tuning parameter in a penalized regression. We study trading-strategy performance to verify our estimation results. If you trade on two variables with similar one-month-ahead return forecasts in different anomaly-base-rate regimes (low vs. high), the variable in the low base-rate regime consistently underperforms the otherwise identical variable in the high base-rate regime.

Publication Bias in Asset Pricing Research

“…All of these different methods lead to similar inferences about the right tail of θ i . Comparable estimates are also found in Chinco, Neuhierl, and Weber (2021), using yet another approach.…”

A New Test of Risk Factor Relevance

“…Many models predict either the time series (Cochrane (2017)) or the crosssection (McLean and Pontiff ( 2016)) of returns. The standard approach to disentangling these models is to use advanced econometrics (Bryzgalova (2017), Chinco, Clark-Joseph, andYe (2019), Feng, Giglio, andXiu (2020), Freyberger, Neuhierl, and Weber (2020), Harvey and Liu (2020), Kozak, Nagel, and Santosh (2020), Chinco, Neuhierl, and Weber (2021)). Instead, we propose a survey-based framework to test whether investors follow the core economic logic behind a given factor model.…”

Necessary Evidence for a Risk Factor's Relevance

“…For example, there are more than ten different macro-finance modeling paradigms that attempt to explain the same aggregate market moments (Cochrane, 2017). The standard approach to disentangling these models is to use advanced econometrics (Chinco et al, 2020;Feng et al, 2020;Freyberger et al, 2020;Harvey and Liu, 2020;Bryzgalova, 2017;Kozak et al, 2018). This paper takes a different tack.…”