Energy, entropy, and arbitrage

Abstract

We introduce a pathwise approach to analyze the relative performance of an equity portfolio with respect to a benchmark market portfolio. In this energy-entropy framework, the relative performance is decomposed into three components: a volatility term, a relative entropy term measuring the distance between the portfolio weights and the market capital distribution, and another entropy term that can be controlled by the investor by adopting a suitable rebalancing strategy. This framework leads to a class of portfolio strategies that allows one to outperform, in the long run, a market that is diverse and sufficiently volatile in the sense of stochastic portfolio theory. The framework is illustrated with several empirical examples.