IDEAS home Printed from https://ideas.repec.org/p/arx/papers/1809.03769.html
   My bibliography  Save this paper

Diversification, Volatility, and Surprising Alpha

Author

Listed:
  • Adrian Banner
  • Robert Fernholz
  • Vassilios Papathanakos
  • Johannes Ruf
  • David Schofield

Abstract

It has been widely observed that capitalization-weighted indexes can be beaten by surprisingly simple, systematic investment strategies. Indeed, in the U.S. stock market, equal-weighted portfolios, random-weighted portfolios, and other naive, non- optimized portfolios tend to outperform a capitalization-weighted index over the long term. This outperformance is generally attributed to beneficial factor exposures. Here, we provide a deeper, more general explanation of this phenomenon by decomposing portfolio log-returns into an average growth and an excess growth component. Using a rank-based empirical study we argue that the excess growth component plays the major role in explaining the outperformance of naive portfolios. In particular, individual stock growth rates are not as critical as is traditionally assumed.

Suggested Citation

  • Adrian Banner & Robert Fernholz & Vassilios Papathanakos & Johannes Ruf & David Schofield, 2018. "Diversification, Volatility, and Surprising Alpha," Papers 1809.03769, arXiv.org.
    • Handle: RePEc:arx:papers:1809.03769
    as

    Download full text from publisher

    File URL: http://arxiv.org/pdf/1809.03769
    File Function: Latest version
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Karatzas, Ioannis & Ruf, Johannes, 2017. "Trading strategies generated by Lyapunov functions," LSE Research Online Documents on Economics 69177, London School of Economics and Political Science, LSE Library.
    2. William F. Sharpe, 1964. "Capital Asset Prices: A Theory Of Market Equilibrium Under Conditions Of Risk," Journal of Finance, American Finance Association, vol. 19(3), pages 425-442, September.
    3. Ioannis Karatzas & Johannes Ruf, 2017. "Trading strategies generated by Lyapunov functions," Finance and Stochastics, Springer, vol. 21(3), pages 753-787, July.
    4. Fernholz, Robert & Shay, Brian, 1982. "Stochastic Portfolio Theory and Stock Market Equilibrium," Journal of Finance, American Finance Association, vol. 37(2), pages 615-624, May.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Kangjianan Xie, 2019. "Leakage of rank-dependent functionally generated trading strategies," Papers 1912.04221, arXiv.org.
    2. Kangjianan Xie, 2020. "Leakage of rank-dependent functionally generated trading strategies," Annals of Finance, Springer, vol. 16(4), pages 573-591, December.
    3. Johannes Ruf & Kangjianan Xie, 2019. "The impact of proportional transaction costs on systematically generated portfolios," Papers 1904.08925, arXiv.org.
    4. Ruf, Johannes & Xie, Kangjianan, 2019. "Generalized Lyapunov functions and functionally generated trading strategies," LSE Research Online Documents on Economics 100023, London School of Economics and Political Science, LSE Library.
    5. Andrey Sarantsev & Blessing Ofori-Atta & Brandon Flores, 2019. "A Stock Market Model Based on CAPM and Market Size," Papers 1907.08911, arXiv.org, revised Apr 2021.
    6. repec:ehl:lserod:102424 is not listed on IDEAS

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Patrick Mijatovic, 2021. "Beating the Market with Generalized Generating Portfolios," Papers 2101.07084, arXiv.org.
    2. Cuchiero, Christa, 2019. "Polynomial processes in stochastic portfolio theory," Stochastic Processes and their Applications, Elsevier, vol. 129(5), pages 1829-1872.
    3. Ricardo T. Fernholz & Caleb Stroup, 2018. "Asset Price Distributions and Efficient Markets," Papers 1810.12840, arXiv.org.
    4. Michael Heinrich Baumann, 2022. "Beating the market? A mathematical puzzle for market efficiency," Decisions in Economics and Finance, Springer;Associazione per la Matematica, vol. 45(1), pages 279-325, June.
    5. Ricardo T. Fernholz & Christoffer Koch, 2018. "The Rank Effect," Papers 1812.06000, arXiv.org.
    6. Johannes Ruf & Kangjianan Xie, 2019. "The impact of proportional transaction costs on systematically generated portfolios," Papers 1904.08925, arXiv.org.
    7. Johannes Ruf & Kangjianan Xie, 2018. "Generalised Lyapunov Functions and Functionally Generated Trading Strategies," Papers 1801.07817, arXiv.org.
    8. Ricardo T. Fernholz & Robert Fernholz, 2022. "Permutation-weighted portfolios and the efficiency of commodity futures markets," Annals of Finance, Springer, vol. 18(1), pages 81-108, March.
    9. Ioannis Karatzas & Donghan Kim, 2020. "Trading strategies generated pathwise by functions of market weights," Finance and Stochastics, Springer, vol. 24(2), pages 423-463, April.
    10. Donghan Kim, 2022. "Market-to-book Ratio in Stochastic Portfolio Theory," Papers 2206.03742, arXiv.org.
    11. Jaehyung Choi & Hyangju Kim & Young Shin Kim, 2021. "Diversified reward-risk parity in portfolio construction," Papers 2106.09055, arXiv.org, revised Sep 2022.
    12. Erhan Bayraktar & Donghan Kim & Abhishek Tilva, 2024. "Quantifying dimensional change in stochastic portfolio theory," Mathematical Finance, Wiley Blackwell, vol. 34(3), pages 977-1021, July.
    13. Diane Wilcox & Tim Gebbie, 2013. "Factorising equity returns in an emerging market through exogenous shocks and capital flows," Papers 1306.5302, arXiv.org, revised Jul 2013.
    14. Erhan Bayraktar & Donghan Kim & Abhishek Tilva, 2024. "Arbitrage theory in a market of stochastic dimension," Mathematical Finance, Wiley Blackwell, vol. 34(3), pages 847-895, July.
    15. Martin Larsson & Johannes Ruf, 2021. "Relative arbitrage: Sharp time horizons and motion by curvature," Mathematical Finance, Wiley Blackwell, vol. 31(3), pages 885-906, July.
    16. Mimouni, Karim & Charfeddine, Lanouar & Al-Azzam, Moh'd, 2016. "Do oil producing countries offer international diversification benefits? Evidence from GCC countries," Economic Modelling, Elsevier, vol. 57(C), pages 263-280.
    17. Ting-Kam Leonard Wong, 2017. "On portfolios generated by optimal transport," Papers 1709.03169, arXiv.org, revised Sep 2017.
    18. Andrew L. Allan & Christa Cuchiero & Chong Liu & David J. Promel, 2021. "Model-free Portfolio Theory: A Rough Path Approach," Papers 2109.01843, arXiv.org, revised Oct 2022.
    19. Ioannis Karatzas & Donghan Kim, 2018. "Trading Strategies Generated Pathwise by Functions of Market Weights," Papers 1809.10123, arXiv.org, revised Mar 2019.
    20. David Itkin & Martin Larsson, 2021. "Open Markets and Hybrid Jacobi Processes," Papers 2110.14046, arXiv.org, revised Mar 2024.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:arx:papers:1809.03769. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: arXiv administrators (email available below). General contact details of provider: http://arxiv.org/ .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.