Portfolio Construction and Risk Budgeting
First published:
ISBN: 9781782721000
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Diversification
Diversification
Introduction
A Primer on Portfolio Theory
Application in Mean–Variance Investing
Diversification
Frictional Costs of Diversification
Risk Parity
Incorporating Deviations from Normality: Lower Partial Moments
Portfolio Resampling and Estimation Error
Robust Portfolio Optimisation and Estimation Error
Bayesian Analysis and Portfolio Choice
Testing Portfolio Construction Methodologies Out-of-Sample
Portfolio Construction with Transaction Costs
Portfolio Optimisation with Options: From the Static Replication of CPPI Strategies to a More General Framework
Scenario Optimisation
Core–Satellite Investing: Budgeting Active Manager Risk
Benchmark-Relative Optimisation
Removing Long-Only Constraints: 120/20 Investing
Performance-Based Fees, Incentives and Dynamic Tracking Error Choice
Long-Term Portfolio Choice
Risk Management for Asset-Management Companies
Valuation of Asset Management Firms
Tail Risk Hedging
Diversification is often called the only free lunch in investing. Yet, what diversification means exactly remains unclear. In this chapter we try to shed more light on the mainstream of so-called diversification-based (often also called risk-based) portfolio construction.
3.1 DIVERSIFICATION REVISITED
Let us start with a simple question. What is the most diversified portfolio? The literature is not short of candidate portfolios. Equal-weighting, minimum-risk or market-cap-weighted portfolios are only the better-known proposals. In an attempt to overcome this ambiguity and to offer an answer to this nagging question some authors even called their own conjecture the most diversified portfolio. While this was clearly designed to defeat competing diversification ideas, we believe the quest to come up with a better diversified portfolio is ill placed, for three reasons.
First, most attempts to provide better diversification can be seen as special cases of classical mean–variance optimisation. “Special” because we need limited information on the side of the decision maker to reconcile these portfolios with first principles in optimal portfolio construction. Only then does the decision
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