Abstract
The residual variance method is the traditional method for measuring portfolio diversification relative to a market index. Problems arise, however, when the market index itself is not appropriately diversified. A diversification measurement (Portfolio Diversification Index), free from market index influences, has been recently introduced. This article explores whether this index is a robust and ‘good’ diversification measure compared with the residual variance method. South African unit trusts are diversification-ranked using the two measures and the results compared to the ranking results of several risk performance measures. Measuring relative concentration levels allows concentration risk to be effectively managed, thereby filling a gap in the Basel accords (which omit concentration risk).
Highlights
As modern financial markets become larger, more highly developed, more transparent and more efficient and with market participants gaining access to ever-increasing data, the tools and analysis employed will develop in tandem
The decrease in the concentration of Fund C is in line with the inverse relationship between diversification and concentration according to theory
In terms of the first objective of this study of whether or not the Portfolio Diversification Index (PDI) is a good diversification measure compared to the RV method, it can be concluded that:
Summary
As modern financial markets become larger, more highly developed, more transparent and more efficient and with market participants gaining access to ever-increasing data, the tools and analysis employed will (and will have to) develop in tandem. With the markets becoming ever more efficient, the skill of attaining above-average risk-adjusted returns will become ever more difficult. The focus of investors and market participants should be prompted to shift towards effective portfolio diversification in order to help ease the task of attaining above-average risk-adjusted returns. Diversification is a major component of portfolio management and a core objective for combining assets in the construction of portfolios, while being woefully misunderstood and complex to model mathematically. The Basel Committee for Banking Supervision (the BCBS) has not included concentration risk in the Basel regulatory capital accords. A proposed treatment of concentration risk was included in the Basel II proposal documents in early 2001, but due to its mathematical complexity and difficulties of implementation, it was subsequently excluded. This research presents a novel methodology to measure relative concentration levels and effectively manage concentration risk, thereby bridging a gap in both the risk literature and the practice of concentration risk mitigation
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