Create Better Diversified High-Conviction Equity Portfolios Using the Portfolio Diversification Index

21 Pages Posted: 30 Mar 2010

See all articles by Dominiek P. Crezée

Dominiek P. Crezée

Erasmus University Rotterdam (EUR) - Department of Business Economics

Laurens Swinkels

Erasmus University Rotterdam (EUR); Robeco Quantitative Investments

Date Written: March 25, 2010

Abstract

We investigate the construction of well-diversified high-conviction equity portfolios, building on Rudin and Morgan (2006) who introduced the Portfolio Diversification Index (PDI) as a new measure of portfolio diversification applied to long/short equity hedge funds in an in-sample period. We are the first to investigate the out-of-sample properties of the PDI. Our research applies a novel portfolio selection algorithm to maximize the PDI of a portfolio of stocks in the S&P 500 Index over 2000 to 2009. We construct equally-weighted, well-diversified portfolios, consisting of 5 to 30 stocks and compare these with randomly selected portfolios of the same stock sizes. Our results indicate that investors using our algorithm to maximize the PDI can improve the diversification of high-conviction equity portfolios. For example, a portfolio of 20 stocks constructed using the algorithm with the PDI behaves out-of-sample as if it contains 10 independent stocks, i.e. a PDI score of 10. Although this is less than the PDI score of 15 achieved in-sample, it is a significant improvement over the PDI score of 7, which occurs with a randomly selected portfolio. Our research is robust with respect to the number of stocks in the investment portfolio and the time period under consideration.

Keywords: Diversification, Portfolio construction, Risk reduction

JEL Classification: G11

Suggested Citation

Crezée, Dominiek P. and Swinkels, Laurens, Create Better Diversified High-Conviction Equity Portfolios Using the Portfolio Diversification Index (March 25, 2010). Available at SSRN: https://ssrn.com/abstract=1578495 or http://dx.doi.org/10.2139/ssrn.1578495

Dominiek P. Crezée

Erasmus University Rotterdam (EUR) - Department of Business Economics ( email )

Netherlands

Laurens Swinkels (Contact Author)

Erasmus University Rotterdam (EUR) ( email )

Burgemeester Oudlaan 50
3000 DR Rotterdam, Zuid-Holland 3062PA
Netherlands

Robeco Quantitative Investments ( email )

Rotterdam, 3000
Netherlands
+31 10 224 2470 (Phone)
+31 10 224 2110 (Fax)

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