Risk reduction and efficiency increase in large portfolios: leverage and shrinkage

Zhao Zhao, Olivier Ledoit and Hui Jiang

No 328, ECON - Working Papers from Department of Economics - University of Zurich

Abstract: We investigate the effects of constraining leverage and shrinking covariance matrix in constructing large portfolios, both theoretically and empirically. Considering a wide variety of setups that involve conditioning or not conditioning the covariance matrix estimator on the recent past (multivariate GARCH), smaller vs. larger universe of stocks, alternative portfolio formation objectives (Global Minimum Variance vs. exposure to profitable factors), and various transaction cost assumptions, we find that a judiciously-chosen shrinkage method always outperforms an arbitrarily-determined leverage constraint. By extending the mathematical connection between leverage and shrinkage from static to dynamic, we provide a new theoretical explanation for our finding from the perspective of degrees of freedom. In addition, both simulation and empirical analysis show that the DCC-NL estimator results in risk reduction and effciency increase in large portfolios as long as a small amount of leverage is allowed, whereas tightening the leverage constraint often hurts a DCC-NL portfolio.

Keywords: DCC; nonlinear shrinkage; leverage constraints; large portfolios; risk reduction; Markowitz mean-variance efficiency; multivariate GARCH (search for similar items in EconPapers)
JEL-codes: C13 C58 G11 (search for similar items in EconPapers)
Date: 2019-07, Revised 2020-01
New Economics Papers: this item is included in nep-ore and nep-rmg
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:zur:econwp:328

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