Asset-Pricing Factors with Economic Targets

We propose a novel method to estimate latent asset-pricing factors that incorporate economic structure. Our estimator generalizes principal component analysis by including economically motivated cross-sectional and time-series moment targets that help to detect weak factors. Cross-sectional targets may capture monotonicity constraints on the loadings of factors or their correlation with fundamental macroeconomic innovations. Time-series targets may reward explaining expected returns or reducing mispricing relative to a benchmark reduced-form model. In an extensive empirical study, we show that these targets nudge risk factors to better span the pricing kernel, leading to substantially higher Sharpe ratios and lower pricing errors than conventional approaches.