Clustering algorithms for Risk-Adjusted Portfolio Construction

This paper presents the performance of seven portfolios created using clustering analysis techniques to sort out assets into categories and then applying classical optimization inside every cluster to select best assets inside each asset category. The proposed clustering algorithms are tested constructing portfolios and measuring their performances over a two month dataset of 1-minute asset returns from a sample of 175 assets of the Russell 1000® index. A three-week sliding window is used for model calibration, leaving an out of sample period of five weeks for testing. Model calibration is done weekly. Three different rebalancing periods are tested: every 1, 2 and 4 hours. The results show that all clustering algorithms produce more stable portfolios with similar volatility. In this sense, the portfolios volatilities generated by the clustering algorithms are smaller when compare to the portfolio obtained using classical Mean-Variance Optimization (MVO) over all the dataset. Hierarchical clustering algorithms achieve the best financial performance obtaining an adequate trade-off between accumulated financial returns and the risk-adjusted measure, Omega Ratio, during the out of sample testing period.