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Sector classification through non-Gaussian similarity

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  • M. Vermorken
  • A. Szafarz
  • H. Pirotte

Abstract

Standard sector classification frameworks present drawbacks that might hinder portfolio managers. This article introduces a new nonparametric approach to equity classification. Returns are decomposed into their fundamental drivers through Independent Component Analysis (ICA). Stocks are then classified according to the relative importance of the identified fundamental drivers for their returns. A method is developed permitting the quantification of these dependencies, using a similarity index. Hierarchical clustering allows for grouping the stocks into new classes. The resulting classes are compared with those from the two-digit Global Industry Classification System (GICS) for US blue chip companies. It is shown that specific relations between stocks are not captured by the GICS framework. The method is tested for robustness and successfully applied to portfolio management.

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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

Volume (Year): 20 (2010)
Issue (Month): 11 ()
Pages: 861-878

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Handle: RePEc:taf:apfiec:v:20:y:2010:i:11:p:861-878

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  1. Roll, Richard, 1992. " Industrial Structure and the Comparative Behavior of International Stock Market Indices," Journal of Finance, American Finance Association, American Finance Association, vol. 47(1), pages 3-41, March.
  2. Andrew J. Patton, 2004. "On the Out-of-Sample Importance of Skewness and Asymmetric Dependence for Asset Allocation," Journal of Financial Econometrics, Society for Financial Econometrics, vol. 2(1), pages 130-168.
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  5. Michel Beine & Pierre-Yves Preumont & Ariane Szafarz, 2006. "Sector diversification during crises: a European perspective," DULBEA Working Papers, ULB -- Universite Libre de Bruxelles 06-07.RS, ULB -- Universite Libre de Bruxelles.
  6. Fama, Eugene F. & French, Kenneth R., 1997. "Industry costs of equity," Journal of Financial Economics, Elsevier, Elsevier, vol. 43(2), pages 153-193, February.
  7. Farrell, James L, Jr, 1974. "Analyzing Covariation of Returns to Determine Homogeneous Stock Groupings," The Journal of Business, University of Chicago Press, vol. 47(2), pages 186-207, April.
  8. Marie Briere & Ariane Szafarz, 2008. "Crisis-Robust Bond Portfolios," ULB Institutional Repository 2013/14150, ULB -- Universite Libre de Bruxelles.
  9. Kole, Erik & Koedijk, Kees & Verbeek, Marno, 2007. "Selecting copulas for risk management," Journal of Banking & Finance, Elsevier, vol. 31(8), pages 2405-2423, August.
  10. Thierry Vessereau, 2000. "Factor Analysis and Independent Component Analysis in Presence of High Idiosyncratic Risks," CIRANO Working Papers 2000s-46, CIRANO.
  11. Peiro, Amado, 1999. "Skewness in financial returns," Journal of Banking & Finance, Elsevier, vol. 23(6), pages 847-862, June.
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