Maximum diversification portfolio in korean equity market

Abstract

This study examines the performance of the maximum diversification portfolio construction approach in the Korean stock market. The long-only portfolio within KOSPI 200 universe from January 2000 to December 2013 is constructed and its performance is compared to a cap-weighted benchmark, an equally weighted portfolio and a global minimum variance portfolio. Risk adjusted portfolio performance and the level of portfolio diversification are measured by annual Sharpe ratio and diversification ratio which is the ratio of weighted average asset volatilities to portfolio volatility, respectively. Overall, the portfolio that is constructed to maximize the diversification ratio delivers an outperforming return and risk-adjusted performance measure in comparisons to other portfolio construction methodologies. It is similar to the results obtained from the prior research by Choueifaty et al. (2008, 2013) on Maximum Diversification Portfolio. Thus, the superior empirical results of Maximum Diversification Portfolio across the Korean stock market as well as the U.S. and European stock market are displayed with its comparisons, the market capitalization weighted benchmark portfolio, an equally weighted portfolio and a global minimum variance portfolio. Even though consistently high Sharpe ratio, diversification ratio and return are obtained by the maximum diversification portfolio construction approach for the whole period, the portfolio delivers the lowest Sharpe ratios when financial crisis hit the global economy in 2008 and its recovery occurred in 2009 as the annual performances of each year are considered. Fama-French three factor regression analysis illustrates that a balanced exposure to the effective risk factors with significantly high alpha can be achieved by the maximum diversification portfolio. The market timing ability of the maximum diversification portfolio is then examined, but the portfolio construction methodology is revealed that it cannot time the market.