Hierarchical PCA and Applications to Portfolio Management

It is widely known that the common risk-factors derived from PCA beyond the first eigenportfolio are generally difficult to interpret and thus to use in practical portfolio management. We explore a alternative approach (HPCA) which makes strong use of the partition of the market into sectors. We show that this approach leads to no loss of information with respect to PCA in the case of equities (constituents of the S&P 500) and also that the associated common factors admit simple interpretations....