Diversity-Weighted Portfolios with Negative Parameter

TL;DR

This paper investigates a negative-parameter diversity-weighted portfolio that inversely weights companies by their market share, demonstrating its almost sure outperformance of the market under certain conditions and exploring practical modifications.

Contribution

It introduces a negative-parameter variant of the diversity-weighted portfolio and proposes modifications that outperform the market under milder assumptions.

Findings

Portfolio outperforms market with probability one

Modifications outperform under milder conditions

Empirical evidence supports outperformance potential

Abstract

We analyze a negative-parameter variant of the diversity-weighted portfolio studied by Fernholz, Karatzas, and Kardaras (Finance Stoch 9(1):1-27, 2005), which invests in each company a fraction of wealth inversely proportional to the company's market weight (the ratio of its capitalization to that of the entire market). We show that this strategy outperforms the market with probability one, under a non-degeneracy assumption on the volatility structure and the assumption that the market weights admit a positive lower bound. Several modifications of this portfolio, which outperform the market under milder versions of this "no-failure" condition, are put forward, one of which is rank-based. An empirical study suggests that such strategies as studied here have indeed the potential to outperform the market and to be preferable investment opportunities, even under realistic proportional transaction costs.