Managing Diversification

23 Pages Posted: 13 Mar 2009 Last revised: 11 Oct 2010

Attilio Meucci

ARPM - Advanced Risk and Portfolio Management

Date Written: April 1, 2010

Abstract

We propose a unified, fully general methodology to analyze and act on diversification in any environment, including long-short trades in highly correlated markets with complex derivatives.

First, we build the diversification distribution, i.e. the distribution of the uncorrelated bets in the portfolio that are consistent with the portfolio constraints. Next, we summarize the wealth of information provided by the diversification distribution into one single diversification index, the effective number of bets, based on the entropy of the diversification distribution. Then, we introduce the mean-diversification efficient frontier, a diversification approach to portfolio optimization. Finally, we describe how to perform mean-diversification optimization in practice in the presence of transaction and market impact costs, by only trading a few optimally chosen securities.

Fully documented code illustrating our approach can be downloaded from MATLAB Central File Exchange.

Keywords: entropy, mean-diversification frontier, transaction costs, market impact, selection heuristics, systematic risk, idiosyncratic risk, principal component analysis, principal portfolios, r-square, risk contributions, random matrix theory

JEL Classification: C1, G11

Suggested Citation

Meucci, Attilio, Managing Diversification (April 1, 2010). Risk, pp. 74-79, May 2009; Bloomberg Education & Quantitative Research and Education Paper. Available at SSRN: https://ssrn.com/abstract=1358533

Attilio Meucci (Contact Author)

ARPM - Advanced Risk and Portfolio Management ( email )

HOME PAGE: http://www.arpm.co/

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