On the Benefits of Equicorrelation for Portfolio Allocation

The importance of modelling correlation has long been recognised in the field of portfolio management with large dimensional multivariate problems are increasingly becoming the focus of research. This paper provides a straightforward and commonsense approach toward investigating a number of models used to generate forecasts of the correlation matrix for large dimensional problems. We find evidence in favour of assuming equicorrelation across various portfolio sizes, particularly during times of crisis. During periods of market calm however, the suitability of the constant conditional correlation model cannot be discounted especially for large portfolios. A portfolio allocation problem is used to compare forecasting methods. The global minimum variance portfolio and Model Confidence Set are used to compare methods, whilst portfolio weight stability and relative economic value are also considered.