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Abstract This paper proposes the development of an improved investor sentiment index (ISI) to apply on the Korea Composite Stock Price Index (KOSPI) and assess the vitality of sentiment‐based factor for explaining critical equity market anomalies in asset pricing in Korea. We follow the methodology of Huang et al. (2015), the align sentiment index, and employ the partial least squares method to overcome the drawbacks of the pioneering BM index of Baker and Wurgler (2006, 2007). Based on the daily trading and price data for individual companies from 2006 to 2021, we construct a novel ISI, which has robust predicting ability for the aggregate stock market return, in comparison to other popular measures of sentiment in the contemporary finance literature. Furthermore, the sentiment‐based factor in this paper captures the small firm effect that the asset pricing modelling, containing the more topical Fama–French five factor modelling (5F‐FF), has struggled to illuminate completely. Given that our results have shown Korean stock market as fairly well‐organised in terms of the availability of the market intelligence, we speculate our results to have important managerial implications for financial regulators in Korea and countries holding similar economic features.
Bouteska et al. (Sun,) studied this question.