TY - JOUR
T1 - What can cluster analysis offer in investing? - Measuring structural changes in the investment universe
AU - Sim, Min Kyu
AU - Deng, Shijie
AU - Huo, Xiaoming
N1 - Publisher Copyright:
© 2020 Elsevier Inc.
PY - 2021/1
Y1 - 2021/1
N2 - 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.
AB - 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.
KW - Asset pricing model
KW - Basis assets
KW - Cluster analysis
KW - Factor model
KW - Investment opportunity set
UR - https://www.scopus.com/pages/publications/85091677234
U2 - 10.1016/j.iref.2020.09.004
DO - 10.1016/j.iref.2020.09.004
M3 - Article
AN - SCOPUS:85091677234
SN - 1059-0560
VL - 71
SP - 299
EP - 315
JO - International Review of Economics and Finance
JF - International Review of Economics and Finance
ER -