Modern Portfolio Theory and Investment Analysis, 9th Edition

8

The Correlation Structure of Security Returns—Multi-Index Models and Grouping Techniques

In Chapter 7 we argued that because of both the huge number of forecasts required and the necessary restrictions on the organizational structure of security analysts, it was not feasible for analysts to directly estimate correlation coefficients. Instead, some structural or behavioral model of how stocks move together should be developed. The parameters of this model can be estimated either from historical data or by attempting to get subjective estimates from security analysts. We have already examined one such model, the single-index model, which assumes that stocks move together only because of a common co-movement with the market. Two other approaches have been widely used to explain and estimate the correlation structure of security returns: multi-index models and averaging techniques.

Multi-index models are an attempt to capture some of the nonmarket influences that cause securities to move together. The search for nonmarket influences is a search for a set of economic factors or structural groups (industries) that account for common movement in stock prices beyond that accounted for by the market index itself. Although it is easy to find a set of indexes that is associated with nonmarket effects over any period of time, as we will see, it is quite another matter to find a set that is successful in predicting covariances that are not market related.

Averaging techniques are at the opposite ...