Large-scale minimum variance portfolio allocation using double regularization

Zhicun Bian, Yin Liao, O’Neill, Michael, Jing Shi and Xueyong Zhang

Journal of Economic Dynamics and Control, 2020, vol. 116, issue C

Abstract: Estimation of time-varying covariances is a crucial input in minimum variance (MV) portfolio allocations. Rolling window-based sample estimates are widely used for this purpose, but they usually suffer from two major issues when applied to a moderately large number of assets: the “curse of dimensionality” and “temporal instability.” Here, we propose a double-regularized estimator for a high dimensional covariance matrix in which we impose both a temporal and cross-sectional sparsity regularization on the sample-based estimates to simultaneously mitigate these two issues. We investigate the performance of our proposed covariance estimator for MV portfolio construction using Monte Carlo experiments and empirical examples. We find that the resulting MV portfolio strikes a good balance between risk and turnover reduction, and produces more accurate equivalent returns after transaction costs are taken into account when compared to four other MV strategies.

Keywords: Large-scale portfolio; Curse of dimensionality; Temporal instability; Doubly regularization; Rolling window (search for similar items in EconPapers)
JEL-codes: C13 C51 C61 G11 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:116:y:2020:i:c:s016518892030107x

DOI: 10.1016/j.jedc.2020.103939

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