Question

1. Another fund manager, Paul, after reviewing John’s portfolio, expresses concern thatthe portfolio involves short-selling certain sectors and putting large weights on other sectors. He suggests that modifying the variance-covariance matrix by reducing the magnitude of the off-diagonal terms from the historical estimates would result in a less extreme portfolio than John’s portfolio . Do you agree? Why or why not? Explain in words without any calculation

Answer 1

In this case the fund manager is expressing concern that the portfolio is involving short selling certain sectors and putting large weights on the other sectors so the fund manager is afraid that there is inappropriate variance covariance matrix existing in the portfolio and he is suggesting to reduce the magnitude of off diagonal terms from the historical estimate because he is believing that having an excess concentration into those stocks in which he has bias that the stocks are going to go upside because he's holding them on his stocks and he is shorting other stocks which is not held by him in the portfolio is reflecting a extreme variance covariance Matrix and the investor should try to modify the the magnitude of off diagonal terms.

I agree with the fund manager because this can be said that there is an extreme formation of position on the part of the investor because of his beliefs as he is going extremely short on those sectors in which has not invested but he has not gone short on the sectors in which has invested so it can be said that the investor is highly biased in his approach towards the portfolio management and it is reflected through extremism of variance covariance Matrix and he should be trying to diversify because of benefits associated with it, rather than being concentrated into particular sector because there would be high covariance matrix associated with his portfolio so he should be trying to to maintain a positive correlation on the lower side in order to decrease his extreme position and have a diversified portfolio which will help in long run.