Markets as Connected Networks

6 July 2022

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Using network theory, we show that one potential benefit of allocating to alternative markets within actively managed portfolios is the opportunity for diversification they offer, and that this diversification has remained more durable during recent crisis periods. This provides further evidence for the ideas of diversification outlined in our earlier paper “Better? Or Just Different?” and, importantly, in our opinion emphasises the benefits of alternative markets during turbulent periods.

What comes to mind when the word ‘network’ is mentioned? Perhaps, computers, transport and social networks initially strike most but it may take a while before financial markets suggest themselves. Using the definition of a network as any group or system of interconnected things, choosing to visualise markets as networks could aid our understanding of them. If you are popular enough to have lots of friends on social media, you may be aware that these companies often map out your own personal social network to cultivate interaction and valuable data. Minimum spanning trees (MSTs) are a type of graphing algorithm which represent all users in a network as nodes and relationships as edges between them. The distance of each edge signifies the strength of the friendship: for instance, more page views, posts, similar shared likes mean a stronger friendship and smaller distances. MSTs search for the subset of edges in the graph which retains each node, but the sum of all edge distances is minimised. The MST is designed to show the representative relationships in the network which could potentially highlight how price information or shocks might propagate through a network of financial markets.

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