Portfolio construction incorporating asymmetric dependence structures: a user's guide

Abstract

Abstract We outline a method of portfolio selection incorporating asymmetric dependency structures using copula functions. Assuming normally distributed marginal returns, we illustrate how asymmetric return correlations affect the efficient frontier and subsequent portfolio performance under a dynamic rebalancing framework. Implementing this methodology within the context of tactically allocating a small set of market indices, we demonstrate several key findings. First, we establish the manner by which the efficient frontier constructed under asymmetric dependence differs from a mean‐variance frontier. By establishing a paper portfolio based on these differences, we find that asymmetric correlation structures do have real economic value. The primary source of this economic value is the ability to better protect portfolio value and reduce the size of any erosion in return relative to the normal portfolio when asymmetric return correlations are accounted for.