What can cluster analysis offer in investing? - Measuring structural changes in the investment universe

Min Kyu Sim, Shijie Deng and Xiaoming Huo

International Review of Economics & Finance, 2021, vol. 71, issue C, 299-315

Abstract: The return on assets of the investment universe tends to form a cluster structure. This study quantifies this strength of the clustering tendency as a single econometric measure, referred to as modularity. Through an empirical study of the US equity market, we demonstrate that the strength of the clustering tendency changes over time with market fluctuations. That is, normal markets tend to have a clear cluster structure (high modularity), while stressed markets tend to have a blurry cluster structure (low modularity). Modularity assesses the quality of an investment opportunity set in terms of potential diversification benefits. Modularity is an important pricing variable in the cross-sectional returns of US stocks. From 1992 to 2015, the average return of the stocks with the lowest sensitivity to modularity (low modularity beta) exceeds that of the stocks with the highest sensitivity (high modularity beta) by approximately 10.49% annually, adjusted for the Fama-French five-factor exposures. The inclusion of modularity as an asset pricing factor, therefore, expands the investment opportunity set for factor-based investors.

Keywords: Cluster analysis; Investment opportunity set; Basis assets; Asset pricing model; Factor model (search for similar items in EconPapers)
JEL-codes: C10 C58 D85 G11 G12 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:71:y:2021:i:c:p:299-315

DOI: 10.1016/j.iref.2020.09.004

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