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Article

Diversifying the Diversifiers and Tracking the Tracking Error: Outperforming Cap-Weighted Indices with Limited Risk of Underperformance

Noël Amenc, Felix Goltz, Ashish Lodh and Lionel Martellini
The Journal of Portfolio Management Spring 2012, 38 (3) 72-88; DOI: https://doi.org/10.3905/jpm.2012.38.3.072
Noël Amenc
is a professor of finance at EDHEC Business School and a director of EDHEC-Risk Institute in London, UK.
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  • For correspondence: noel.amenc@edhec-risk.com
Felix Goltz
is head of applied research at the EDHEC-Risk Institute at EDHEC Business School in Nice, France.
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  • For correspondence: felix.goltz@edhec-risk.com
Ashish Lodh
is a quantitative analyst with the EDHEC-Risk Institute at EDHEC Business School in Nice, France.
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  • For correspondence: ashish.lodh@edhec-risk.com
Lionel Martellini
is a professor of finance at EDHEC Business School and scientific director of EDHEC-Risk Institute in Nice, France.
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  • For correspondence: lionel.martellini@edhec.edu
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Abstract

A number of quantitative or fundamental weighting schemes have been shown to produce robust outperformance with respect to standard cap-weighted equity indices over long time periods. Over periods ranging from a few months to a few years, however, such alternative weighting schemes can generate substantial downside risk relative to cap-weighted indices, which would be a source of concern for most investment managers or chief investment officers. In this article, the authors focus on two reasonable proxies for well-diversified, efficient frontier portfolios, namely, the maximum Sharpe ratio (MSR) portfolio and the global minimum volatility (GMV) portfolio. They address the question of how to use these building blocks to design an improved equity benchmark while satisfying target levels of average and extreme tracking error with respect to cap-weighted indices. The authors find that robust proxies for the GMV portfolio provide defensive exposure to equity that does well in adverse market conditions, while robust proxies for MSR portfolios provide greater access to the upside of equity markets. Because the relative performance of these two diversification approaches depends on market conditions, they expect a combination of both approaches to lead to a smoother conditional performance and higher probability of outperformance of the cap-weighted index, an intuition that is confirmed in empirical tests. Empirical analysis also suggests that “diversifying the diversifiers” still leads to high levels of relative downside risk, in particular when the performance of cap-weighted indices is unusually strong. In this context, the authors introduce an explicit relative risk control mechanism designed to reduce the consequences of severe short-term underperformance with respect to the cap-weighted index and confirm through out-of-sample empirical tests that “tracking the tracking error” would allow investors to achieve better access to outperformance per unit of extreme relative risk taken. Overall, the results reported in this article suggest that it is possible to achieve robust outperformance versus cap-weighted indices by diversifying model risk and by controlling relative risk compared to the cap-weighted indices.

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The Journal of Portfolio Management: 38 (3)
The Journal of Portfolio Management
Vol. 38, Issue 3
Spring 2012
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Diversifying the Diversifiers and Tracking the Tracking Error: Outperforming Cap-Weighted Indices with Limited Risk of Underperformance
Noël Amenc, Felix Goltz, Ashish Lodh, Lionel Martellini
The Journal of Portfolio Management Apr 2012, 38 (3) 72-88; DOI: 10.3905/jpm.2012.38.3.072

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Diversifying the Diversifiers and Tracking the Tracking Error: Outperforming Cap-Weighted Indices with Limited Risk of Underperformance
Noël Amenc, Felix Goltz, Ashish Lodh, Lionel Martellini
The Journal of Portfolio Management Apr 2012, 38 (3) 72-88; DOI: 10.3905/jpm.2012.38.3.072
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  • Article
    • Abstract
    • DIVERSIFICATION ACROSS EQUITY PORTFOLIO OPTIMIZATION STRATEGIES
    • RELATIVE RISK–CONTROLLED VERSIONS OF OPTIMIZED PORTFOLIOS
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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