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Feasible GLS (FGLS) with Estimated Covariance Structure

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Generalized Least Squares (GLS) for Non-Spherical Errors→→Least Squares Regression: Fundamentals and DerivationQuasi-Maximum Likelihood Estimation
estimation heteroskedasticity fgls

Core Idea

FGLS estimates the error covariance matrix from residuals, then applies GLS using the estimated structure. While more practical than GLS (which requires knowing covariance a priori), FGLS is sensitive to misspecification of the covariance form and sacrifices some efficiency through the two-step estimation.

Explainer

From your study of GLS, you know the fundamental problem it solves: when errors have non-constant variance (heteroskedasticity) or are correlated across observations, OLS is still unbiased but no longer efficient, and standard errors are wrong. GLS corrects this by pre-multiplying the model by the inverse square root of the error covariance matrix Ω, transforming the data into a form where OLS is once again the best linear unbiased estimator. The catch is that GLS requires knowing Ω — the exact structure of the errors — which in practice you almost never do. FGLS (Feasible GLS) resolves this by estimating Ω from the data itself, then using that estimate in place of the true covariance structure.

The mechanics are a two-step procedure. In Step 1, you run OLS and collect the residuals. You then use those residuals to estimate the covariance structure — the specific approach depends on what form of misspecification you suspect. For heteroskedasticity, you might regress squared residuals on the regressors or their functions to estimate how variance scales with covariates. For serial correlation, you might estimate an AR(1) process from the residuals to get ρ, the autocorrelation coefficient. This gives you Ω̂, your estimate of the covariance matrix. In Step 2, you apply GLS using Ω̂ in place of Ω: transform the data by pre-multiplying by Ω̂^(-1/2) and run OLS on the transformed model. The resulting estimator is FGLS.

The key tradeoff relative to true GLS is that FGLS is no longer exactly optimal in finite samples, because Ω̂ is itself estimated with error. This introduces a form of generated-regressor bias that shrinks as sample size grows. In large samples, FGLS is asymptotically equivalent to GLS — both achieve the same efficiency gains over OLS. In small samples, however, the two-step estimation can introduce substantial noise, and FGLS may actually perform worse than plain OLS if the covariance model is poorly estimated. The practical rule: FGLS pays off most when (a) the sample is large enough for the first-stage covariance estimation to be precise, and (b) the misspecification (heteroskedasticity or autocorrelation) is severe enough to make the efficiency gain worth the additional complexity.

The deeper sensitivity is misspecification of the covariance form. If you assume heteroskedasticity follows a particular parametric pattern but the true pattern differs, your Ω̂ is wrong in a systematic way, and FGLS can perform badly — potentially worse than either OLS or the correct GLS. This is why practitioners often prefer heteroskedasticity-robust standard errors (which leave OLS point estimates unchanged but correct the inference) over FGLS for heteroskedasticity problems: they require no assumption about the form of heteroskedasticity. FGLS is most natural when the covariance structure is well-motivated theoretically — for example, in feasible WLS (weighted least squares), where you have strong prior reason to believe variance is proportional to a particular variable, or in panel data settings with known autocorrelation structures. Knowing when to use FGLS versus robust standard errors versus a fully specified panel estimator is the judgment call that separates mechanical application from genuine econometric skill.

Practice Questions 5 questions

Prerequisite Chain

Understanding Zero → The Number Zero → Counting to Five → Counting to 10 → Counting to 20 → Counting a Set of Objects Up to 20 → Cardinality: The Last Number Counted → Matching Numerals to Quantities → Subitizing Small Quantities → Addition Within 10 → Number Bonds to 10 → Addition Within 20 → Doubles and Near Doubles → Doubles Facts Within 10 → Near Doubles Facts Within 20 → Mental Math Strategies for Addition → Mental Math: Adding and Subtracting Tens → Addition Within 100 → Repeated Addition as Multiplication → Multiplication as Equal Groups → Multiplication: Arrays → Basic Multiplication Facts (0s, 1s, 2s, 5s, 10s) → Multiplication Facts Within 100 → Division as Equal Sharing → Division as Grouping (Measurement Division) → Division: Grouping (Repeated Subtraction) Model → Division: Fair Sharing Model → Division as Equal Sharing → Division as Grouping → Basic Division Facts → Division Facts Within 100 → Multiplication and Division Fact Families → Relationship Between Multiplication and Division → Division Facts as Inverse of Multiplication → Remainders and Quotients in Division → Division Word Problems → Multi-Step Word Problems → Solving Multi-Step Word Problems → Multiplication Word Problems → Division Word Problems → Introduction to Long Division → Factors and Multiples → Prime and Composite Numbers → Equivalent Fractions → Relating Fractions and Decimals → Decimal Place Value → Integers and the Number Line → Comparing and Ordering Integers → Absolute Value → Adding Integers → Subtracting Integers → Multiplying Integers → Dividing Integers → Unit Rates → Proportions → Percent Concept → Converting Between Fractions, Decimals, and Percents → Operations with Rational Numbers → Two-Step Equations → Solving Multi-Step Equations → Equations with Variables on Both Sides → Angle Pairs: Complementary, Supplementary, and Vertical → Parallel Lines and Transversals → Corresponding Angles → Alternate Interior Angles → Triangle Angle Sum Theorem → Exterior Angle Theorem → Triangle Inequality Theorem → Similar Triangles: AA Similarity → Similar Triangles: SSS and SAS Similarity → Proportions in Similar Triangles → Right Triangle Trigonometry Introduction → Sine, Cosine, and Tangent Ratios → Trigonometric Ratios Review → Radian Measure → Converting Between Degrees and Radians → The Unit Circle → Graphing Sine and Cosine → Graphing Tangent and Reciprocal Trigonometric Functions → Derivatives of Trigonometric Functions → Antiderivatives → Indefinite Integrals → Basic Integration Rules → Riemann Sums → Definite Integral Definition → Probability Density Functions and Continuous Distributions → Cumulative Distribution Functions → Continuous Random Variables → Probability Density Functions → Expected Value → Weak Law of Large Numbers → Probability Axioms and Rules → Conditional Probability → Independence of Events → Sampling Distributions → Standard Error of Estimators → Hypothesis Testing: Framework and Logic → P-values and Statistical Significance → Effect Size and Practical Significance → Hypothesis Testing: Framework and Logic → Z-Tests and T-Tests for Means → One-Sample Z-Test for Means → One-Sample and Two-Sample T-Tests → Inference in Linear Regression → Prediction Intervals in Regression → Linear Regression Basics → Residuals and Goodness of Fit (R²) → Simple (Bivariate) OLS Regression → Classical OLS Assumptions (Gauss-Markov) → Multiple Regression → Interpreting Regression Coefficients → Hypothesis Testing in Regression → F-Test and Joint Significance → White Test and Detection of Heteroskedasticity → Generalized Least Squares (GLS) for Non-Spherical Errors → Feasible GLS (FGLS) with Estimated Covariance Structure

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