Quantile return connectedness of theme factors and portfolio implications: Evidence from the US and China

Abstract

Understanding factor interplay is crucial for effective portfolio management and risk mitigation. This study delves into quantile return connectedness among theme factors in the US and Chinese markets through static and dynamic analyses. In our static analysis, we examine the raw, conditional, and aggregate connectedness across various conditional return quantiles. A bootstrap residual process is conducted to identify statistically significant results. Our findings reveal marked disparities in significant transmitters and receivers across different conditional quantiles. Furthermore, there are notable contrasts in significant results between raw and conditional connectedness measures. For different connectedness measures, we observe a U-shaped relationship between total connectedness and conditional quantiles, underscoring the varying degrees of interplay among theme factors under different market conditions. In the dynamic analysis, we evaluate the performance of the minimum connectedness portfolio (MCoP), built utilizing time-varying connectedness information. The MCoP, built using left-tail connectedness information, demonstrates superior performance compared to its peers — the minimum conditional correlation portfolio and the minimum variance portfolio — in terms of the Sortino ratio and cumulative returns. Our study holds substantial implications for asset allocation, risk management strategies, and policy formulation. It provides valuable insights for constructing robust portfolios and enhancing overall market stability.