Principal Portfolios: Recasting the Efficient Frontier

A new method of analyzing the efficient portfolio problem under the assumption that short sales are allowed is presented. It is based on the remarkable finding that the original asset set can be reorganized as a set of uncorrelated portfolios, here named principal portfolios. The original problem of portfolio selection from the existing, correlated assets is thereby traded for the reduced problem of choosing from a set of uncorrelated portfolios. These portfolios constitute a new investment environment of uncorrelated assets, thereby providing significant conceptual and practical simplification in any portfolio optimization process such as the determination of the efficient frontier. The principal portfolio analysis of the efficient frontier reveals new features of the volatility structure of the optimal portfolios.