Measuring the Diversification and Hedging Properties of Correlations

Portfolio diversification and hedging have become more complicated in large part due to adverse developments in the time-varying behavior of correlations, and consequently there is renewed appreciation for understanding how correlation dynamics affect the diversification and hedging properties associated with various sets of assets and investment strategies. This article introduces the normalized variance of the minimum correlation portfolio (NVMCP) as a simple measure of the diversification and hedging potential afforded by the correlations of an investment universe from an optimal portfolio perspective: it quantifies the maximum degree of diversification or hedging that can be achieved from a fully invested portfolio that is optimized to have the lowest possible correlation across assets. The NVMCP is very flexible in that it can be used to compare diversification and hedging potential across assets and across time periods, it can incorporate constraints to reflect investment restrictions that affect the capacity to diversify or hedge, and it can be used as a benchmark to evaluate the diversification and hedging characteristics of existing portfolios. A key feature of the NVMCP is that it reflects diversification properties associated with positive correlations as well as hedging properties associated with negative correlations. This is a significant advantage over several existing measures, particularly those based on principal components analysis (PCA) which can produce misleading estimates of diversification when there are negative correlations among assets