Interconnectedness risk and active portfolio management: the information-theoretic perspective

Eduard Baitinger and Jochen Papenbrock

Abstract

Today’s asset management academia and practice are dominated by mean–variance thinking. Consequently, this usually leads to the quantification of the dependence structure of asset returns by the covariance or the Pearson correlation coefficient matrix. The respective dependence measures are linear by construction and hence unable to detect nonlinear dependencies. This paper tackles the described concern with regard to financial networks and their implementation in active investment strategies. We discuss the mutual information measure, which is an information-theoretic concept and is able to detect linear and nonlinear dependencies. The empirical part of this paper extensively compares mutual-information-based networks with correlation-based networks on a stand-alone basis and in the framework of active investment strategies.