Application in Mean–Variance Investing

Bernd Scherer


2.1.1 The correlation problem

Few investors are aware that the definition of the investment universe itself has a considerable impact on the outcome of portfolio construction. If, for example, the investment universe is constrained to government bonds and emerging market bonds, it is obvious that all combinations are efficient and investors are likely to place a considerable allocation in emerging market bonds. However, as soon as high-yield bonds and emerging market equities are introduced, this situation might change due to the correlation between these assets.

To increase the transparency of the asset allocation process and to avoid the accumulation of estimation errors, portfolio optimisation should be limited to groups of assets that have high intragroup and low intergroup correlations.11The selection of asset classes suitable for optimisation is both quantitative and judgemental. The benefit of this correlation-guided asset class definition is a weakened sensitivity of the optimal portfolio solution with respect to mean return estimates (which carry the highest estimation error, as can be seen from Appendix A of Chapter

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