Feature selection for portfolio optimization

Thomas Trier Bjerring, Omri Ross and Alex Weissensteiner ()
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Thomas Trier Bjerring: Technical University of Denmark
Omri Ross: Technical University of Denmark
Alex Weissensteiner: Technical University of Denmark

Annals of Operations Research, 2017, vol. 256, issue 1, No 3, 40 pages

Abstract: Abstract Most portfolio selection rules based on the sample mean and covariance matrix perform poorly out-of-sample. Moreover, there is a growing body of evidence that such optimization rules are not able to beat simple rules of thumb, such as 1/N. Parameter uncertainty has been identified as one major reason for these findings. A strand of literature addresses this problem by improving the parameter estimation and/or by relying on more robust portfolio selection methods. Independent of the chosen portfolio selection rule, we propose using feature selection first in order to reduce the asset menu. While most of the diversification benefits are preserved, the parameter estimation problem is alleviated. We conduct out-of-sample back-tests to show that in most cases different well-established portfolio selection rules applied on the reduced asset universe are able to improve alpha relative to different prominent factor models.

Keywords: Portfolio optimization; Parameter uncertainty; Feature selection; Agglomerative hierarchical clustering (search for similar items in EconPapers)
Date: 2017
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Citations: View citations in EconPapers (5)

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DOI: 10.1007/s10479-016-2155-y

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