The Matrix Effective Rank: Measuring the Dimensionality of a Universe of Assets
Quantifying how diversified is a universe of assets is an open problem in quantitative finance, partly because there is no definite formula for diversification^{1}.
Let’s make the (reasonable) assumption that the way assets are moving together within a universe is important for its diversification.
This in turn makes asset correlations within a universe important in determining how diversified it is.
For example, consider the following correlation matrices:
\[C_1 = \begin{bmatrix} 1 & 0 & 0 \newline 0 & 1 & 0 \newline 0 & 0 & 1 \end{bmatrix}\] \[C_2 = \begin{bmatrix} 1 & 1 & 0 \newline 1 & 1 & 0 \newline 0 & 0 & 1 \end{bmatrix}\] \[C_3 = \begin{bmatrix} 1 & 0.99 & 0.98 \newline 0.99 & 1 & 0.99 \newline 0.98 & 0.99 & 1 \end{bmatrix}\]Intuitively, $C_1$, $C_2$ and $C_3$ are describing asset correlations within 3 very different universe of 3 assets:
 $C_1$ represents a universe made of 3 different assets
 $C_2$ represents a universe made of only 2 different assets^{2}
 $C_3$ represents a universe made of essentially 1 asset^{3}
So, question is, would it be possible to “transform” an asset correlation matrix into a measure of diversification for the associated universe?
The matrix effective rank, introduced by Roy and Vetterli^{4} as a realvalued extension of the matrix rank with roots in information theory, can be used in this context.
Indeed, the effective rank of $C_1$, $C_2$ and $C_3$ matches quite closely the intuition above:
 The effective rank of $C_1$ is equal to 3
 The effective rank of $C_2$ is equal to ~1.89
 The effective rank of $C_3$ is equal to ~1.06
In this post, after providing the formal definition of the matrix effective rank and some of its properties, I will illustrate one of its possible usage in principal components analysis.
Notes:
 A Google sheet corresponding to this post is available here
Mathematical preliminaries
Definition
Let be:
 $A \in \mathcal{M}(\mathbb{R}^{n \times n})$, $n \ge 2$, a non null real symmetric positive semidefinite matrix
 $\lambda_1 \ge \lambda_2 \ge … \ge \lambda_n \ge 0$ the eigenvalues of the matrix $A$^{5}
 $\rho_1 \ge \rho_2 \ge … \ge \rho_n \ge 0$ the standardized eigenvalues of the matrix $A$ defined by $\rho_i = \frac{\lambda_i}{\sum_{i=1}^{n} \lambda_i}$, $i=1..n$
The effective rank of the matrix $A$ is defined as the exponential Shannon entropy of its standardized eigenvalues^{6}, that is
\[\textrm{erank}(A) = e^{ \sum_{i=1}^{n} \rho_i \ln(\rho_i)}\]Interpretation
The well known matrix rank corresponds to the (algebraic) dimension of the vector space generated by the columns of a matrix  the matrix range  and does not take into account the actual geometry of this vector space.
For example, both matrices $C_1$ and $C_3$ are of rank 3, so that their range is $\mathbb{R}^3$, but:
 The range of $C_1$ is geometrically identical to $\mathbb{R}^3$, as illustrated on figure 1
 The range of $C_3$ is geometrically close to a line in $\mathbb{R}^3$, as illustrated on figure 2
On the other hand, the matrix effective rank is directly influenced by the geometrical shape of the matrix range^{4} and represents the true, effective, dimension of this vector space.
Thus, when computed on an asset correlation (or covariance) matrix, the effective rank measures the dimensionality of the associated universe of assets.
Main properties
Below are the main properties of the matrix effective rank established in Roy and Vetterli^{4}.
Let $A, B \in \mathcal{M}(\mathbb{R}^{n \times n})$, $n \ge 2$, be two non null real symmetric positive semidefinite matrices.
Property 1: $1 \le \textrm{erank}(A) \le \textrm{rank}(A) \le n$
Property 2: $\textrm{erank}(A)$ takes all the values in the real interval $[1, \textrm{rank}(A)]$
Property 3: $\textrm{erank}(A) = \textrm{erank}(A {}^t)$
Property 4: $\textrm{erank}(A+ B) \le \textrm{erank}(A) + \textrm{erank}(B)$
Example of usage  Principal components analysis (PCA)
As an illustration of a possible usage, I will reproduce the results of Fleming and Kroeske^{7} about the explanatory power of the number of components indicated by the matrix effective rank in principal components analysis.
Data
Fleming and Kroeske^{7} use daily and weekly closing prices of assets belonging to 3 different universes^{8} over the period 1992  2012.
In this post, I use monthly closing prices^{9} of the Sector SPDR ETFs^{10} over the period 2000  2021^{11}.
Methodology
Similar to Fleming and Kroeske^{7}, I use a rolling window approach.
At the end of each month:
 The covariance matrix $\Sigma$ of the ETFs is computed over the previous 24 months of ETF returns data^{12}, using the Portfolio Optimizer endpoint
/assets/covariance/matrix
 The effective rank of $\Sigma$ is determined, using the Portfolio Optimizer endpoint
/assets/covariance/matrix/effectiverank
 The principal components of $\Sigma$ are determined, using the Portfolio Optimizer endpoint
/portfolio/analysis/factors/implicit
 The proportion of the total variance explained by the $\left \lceil{\textrm{erank}(A)}\right \rceil$ principal components of $\Sigma$ is computed
Results
The results obtained are remarkably consistent with those of Fleming and Kroeske^{7}:
 The effective rank varies a lot through time^{13}, as illustrated on figure 3
 The proportion of total variance explained is both very high and very stable through time^{14}, as illustrated on figure 4
Conclusion
I hope you enjoyed this first post of 2022!
Another possible usage of the matrix effective rank, hinted in Fleming and Kroeske^{7}, is to use it as an indicator of systemic risk.
Indeed, it appears that the matrix effective rank bottoms around market crashes (financial crisis of 2007–2008, Corona crisis of 2020…).
Maybe a subject for another time…
–

See Meucci, Attilio, Managing Diversification (April 1, 2010). Risk, pp. 7479, May 2009, Bloomberg Education & Quantitative Research and Education Paper. ↩

The first asset and the second asset are moving in sync, and so are identical from a diversification perspective. ↩

The matrix $C_3$ is a small perturbation of the equicorrelation matrix $\begin{bmatrix} 1 & 1 & 1 \newline 1 & 1 & 1 \newline 1 & 1 & 1 \end{bmatrix}$ which represents a universe where all the assets are moving in sync. ↩

See Olivier Roy and Martin Vetterli, The effective rank: A measure of effective dimensionality, 15th European Signal Processing Conference, 2007. ↩ ↩^{2} ↩^{3}

The eigenvalues of a non null real symmetric positive semidefinite matrix are all real, nonnegative and at least one of them is strictly positive. ↩

With the convention that $0 \ln(0) = 0$. ↩

See Fleming, Brian and Kroeske, Jens, An InformationTheoretic Approach to Dimension Reduction of Financial Data (June 3, 2013). ↩ ↩^{2} ↩^{3} ↩^{4} ↩^{5}

U.K. spot government bond yields across 13 maturities, 66 U.S. equity industries and 96 multiasset class data series including equities, government bonds, corporate bonds, currencies and commodities. ↩

Adjusted for splits and dividends. ↩

Provided by Alpha Vantage. ↩

As they become available through time. ↩

The 24 months of data correspond to the 2 years of data used by Fleming and Kroeske^{7}. ↩

Ranging from ~1.60 to ~4.18. ↩

Ranging from ~87% to ~96%. ↩