Sparse spanning portfolios and under-diversification with second-order stochastic dominance

Stelios Arvanitis, Olivier Scaillet and Nikolas Topaloglou
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Stelios Arvanitis: Athens University of Economics and Business - Department of Economics
Nikolas Topaloglou: Athens University of Economics and Business

No 24-08, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

Abstract: We develop and implement methods for determining whether relaxing sparsity constraints on portfolios improves the investment opportunity set for risk-averse investors. We formulate a new estimation procedure for sparse second-order stochastic spanning based on a greedy algorithm and Linear Programming. We show the optimal recovery of the sparse solution asymptotically whether spanning holds or not. From large equity datasets, we estimate the expected utility loss due to possible under-diversification, and find that there is no benefit from expanding a sparse opportunity set beyond 45 assets. The optimal sparse portfolio invests in 10 industry sectors and cuts tail risk when compared to a sparse mean-variance portfolio. On a rolling-window basis, the number of assets shrinks to 25 assets in crisis periods, while standard factor models cannot explain the performance of the sparse portfolios.

Keywords: Nonparametric estimation; stochastic dominance; spanning; under-diversification; greedy algorithm; Linear Programming (search for similar items in EconPapers)
JEL-codes: C13 C14 C44 C58 C61 D81 G11 (search for similar items in EconPapers)
Pages: 61 pages
Date: 2024-01
New Economics Papers: this item is included in nep-upt
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Citations: View citations in EconPapers (1)

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Working Paper: Sparse spanning portfolios and under-diversification with second-order stochastic dominance (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp2408

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