Interconnectedness Risk and Active Portfolio Management: The Information-Theoretic Perspective

Abstract

Today's asset management academia and practice is dominated by mean-variance thinking. In consequence, this leads to the quantification of the dependence structure of asset returns by the covariance or the Pearson's correlation coefficient matrix. However, the respective dependence measures are linear by construction and hence unable to detect non-linear dependencies. This article tackles the described concern with regard to the previous publication of Baitinger and Papenbrock (2017). We introduce the mutual information measure, which is an information-theoretic concept and able to detect linear and non-linear dependencies. Next, correlation-based networks are extensively compared to mutual information-based networks. Lastly, the empirical study of Baitinger and Papenbrock (2017) is replicated using mutual information-based networks.

Keywords: Mutual Information, Pearson's Correlation Coefficient, Financial Networks, Active Portfolio Management, Centrality, Portfolio Optimization

JEL Classification: G10, G11, C61