The Attenuation of Idiosyncratic Risk under Alternative Portfolio Weighting Strategies: Recent Evidence from the UK Equity Market

Abstract

In this study, we investigate the attenuation of idiosyncratic risk and corresponding benefits of diversification for equally weighted and market capitalisation weighted portfolios in the UK Equity Market over 2002 -2012. We analyse the absolute benefits of risk reduction by testing the homogeneity of variances of portfolios of different sizes using Levene's Test. Next, we perform a cost-benefit analysis to determine the return benefit of diversification from a practical perspective. We find that the absolute benefits of diversification for an equally weighted portfolio are greater in the 'crisis' than 'pre-crisis' period, but when we analyse the results from a practical perspective the benefits fall dramatically and the results are reversed. When comparing the benefits of market capitalisation weighted and equally weighted portfolios, we note that the benefits of diversification tend to be greater for an equally weighted portfolio for small portfolios but that a crossover occurs as the size of the portfolio increases. The relative benefits of diversification under these different weighting strategies are thus highly dependent upon the state of the market and further study is needed to determine why the diversification benefits for the alternative weighting strategies decay at varying rates.

On multiobjective combinatorial optimization and dynamic interim hedging of efficient portfolios

“…Studying the benefits of diversification of small and large portfolios using alternative weighting schemes, Daryl and Shawn () found the benefits of diversification favored small equally weighted portfolios compared to market capitalized weighted portfolios during both “crisis” and “noncrisis” economic scenarios. The authors also report a crossover effect as the portfolio size increased.…”

“…His study reports how overweighting a portfolio toward high‐beta assets may actually result in lower Sharpe ratios compared to levering low‐beta assets. Similarly, Daryl and Shawn () report that the relative benefits of diversification tend to be greater for small portfolios that are equally weighted (in contrast to MV weighted) with a crossover effect as the size of the portfolio increases. By contrast, Gârleanu and Pedersen () analytically derive a closed‐form optimal dynamic portfolio policy that is appropriate when trading is costly and security returns are predictable by signals with different mean‐reversion speeds.…”