Comparing Factor Models Under Regime Switching

We compare factor pricing models using the “test-asset irrelevance” result but under regime switching. We show that the unconditional squared Sharpe ratio measure is no longer appropriate for model comparison when returns are subject to regime shifts. However, conditional on a given regime, model comparison can be performed using the conditional squared Sharpe ratio metric. We find that the Fama-French six-factor model that employs a cash-based profitability factor, the Barillas-Shanken six-factor model, and the Stambaugh-Yuan four-factor model are jointly the best-performing models under the bull regime. However, no model performs significantly better than others under the bear regime. Importantly, these findings are robust to regime uncertainty. We also find that unconditional model rankings closely mirror those in bull markets, overstating the superiority of the models identified as best performing in expansions by ignoring the performance convergence across models that emerges in downturns. This underscores the importance of evaluating factor models conditional on market regimes.

This paper was accepted by Lukas Schmid, finance.

Supplemental Material: The online appendix and data files are available at https://doi.org/10.1287/mnsc.2025.04942.