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A General Framework for Portfolio Theory. Part II: Drawdown Risk Measures

Target Matrix Estimators in Risk-Based Portfolios

Department of Economics and Business Studies, University of Genova, Via Vivaldi, 5, 16126 Genova, Italy
Risks 2018, 6(4), 125;
Received: 14 October 2018 / Revised: 29 October 2018 / Accepted: 2 November 2018 / Published: 5 November 2018
(This article belongs to the Special Issue Computational Methods for Risk Management in Economics and Finance)
Portfolio weights solely based on risk avoid estimation errors from the sample mean, but they are still affected from the misspecification in the sample covariance matrix. To solve this problem, we shrink the covariance matrix towards the Identity, the Variance Identity, the Single-index model, the Common Covariance, the Constant Correlation, and the Exponential Weighted Moving Average target matrices. Using an extensive Monte Carlo simulation, we offer a comparative study of these target estimators, testing their ability in reproducing the true portfolio weights. We control for the dataset dimensionality and the shrinkage intensity in the Minimum Variance (MV), Inverse Volatility (IV), Equal-Risk-Contribution (ERC), and Maximum Diversification (MD) portfolios. We find out that the Identity and Variance Identity have very good statistical properties, also being well conditioned in high-dimensional datasets. In addition, these two models are the best target towards which to shrink: they minimise the misspecification in risk-based portfolio weights, generating estimates very close to the population values. Overall, shrinking the sample covariance matrix helps to reduce weight misspecification, especially in the Minimum Variance and the Maximum Diversification portfolios. The Inverse Volatility and the Equal-Risk-Contribution portfolios are less sensitive to covariance misspecification and so benefit less from shrinkage. View Full-Text
Keywords: estimation error; shrinkage; target matrix; risk-based portfolios estimation error; shrinkage; target matrix; risk-based portfolios
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Neffelli, M. Target Matrix Estimators in Risk-Based Portfolios. Risks 2018, 6, 125.

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Neffelli M. Target Matrix Estimators in Risk-Based Portfolios. Risks. 2018; 6(4):125.

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Neffelli, Marco. 2018. "Target Matrix Estimators in Risk-Based Portfolios" Risks 6, no. 4: 125.

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