Quant investing in cluster portfolios

Abstract

This paper discusses portfolio construction for investing in N given assets, eg, constituents of the Dow Jones Industrial Average (DJIA) or large cap stocks, based on partitioning the investment universe into clusters. The clusters are determined from the trailing correlation matrix via an information theoretic algorithm that uses thresholding of high-correlation pairs. We calculate the principal eigenvector of each cluster from its correlation matrix and the corresponding eigenportfolio. The cluster portfolios are combined into a single N-asset portfolio based on a weighting scheme for the clusters. Various tests conducted on components of the DJIA and a 30-stock basket of large cap stocks indicate that the new portfolios are superior to the DJIA and other mean–variance portfolios in terms of their risk-adjusted returns from 2009 to 2019. We also tested the cluster portfolios for a larger basket of 373 Standard & Poor’s 500 components from 2001 to 2019. The test results provide convincing evidence that a cluster-based portfolio can outperform passive investing.