On shrinkage covariance estimators: how inefficient is 1/N strategy of covariance estimation for portfolio selection in foreign exchange market?

Muhammad Husnain, Shamrez Ali, Qaiser Munir and Ammar Jreisat

Cogent Economics & Finance, 2024, vol. 12, issue 1, 2431542

Abstract: We investigate portfolio selection performance as in Markowitz by evaluating variance matrix estimation criteria in the currency market. This study challenges theoretically rigorous shrinkage covariance estimators using multiple evaluation metrics: systematic loss function, risk profile of minimum variance portfolios, Herfindahl index, financial efficiency, and concentration level. We assess out-of-sample performance across conventional models, factor models, linear shrinkage estimators, and equally weighted portfolios by applying mean-variance criteria and minimum variance framework to the 10 most traded currencies. Our findings reveal that mean-variance optimal portfolios are concentrated, counterintuitive, and highly sensitive to optimizer input choices in currency markets. We discovered that shrinkage estimators do not provide additional benefits to investors and fund managers regarding systematic loss function and minimum variance portfolio risk profiles. The research highlights critical limitations in traditional portfolio construction approaches, demonstrating that portfolios built using mean-variance criteria are prone to significant input data sensitivity and tend to create overly concentrated investments. Consequently, the study suggests that investors and fund managers should exercise caution when selecting covariance estimators and consider exploring more diversified strategies to optimize portfolio performance in foreign exchange markets.This study critically evaluates the efficacy of covariance estimators in optimizing portfolios within the foreign exchange market, highlighting limitations of traditional and sophisticated shrinkage methods. Through comprehensive analysis, it demonstrates that mean-variance optimal portfolios are prone to input sensitivity and concentration, offering little advantage to fund managers over simpler 1/N diversification strategies. With a comprehensive dataset spanning decades, the research provides actionable insights into minimizing estimation errors and improving portfolio stability. The findings challenge prevailing methodologies, emphasizing simplicity and diversification to enhance decision-making for investors, fund managers, and policymakers navigating the complexities of currency markets.

Date: 2024
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DOI: 10.1080/23322039.2024.2431542

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