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Steps to replicate: Take the correlation matrix of a sample of stocks in the SP500, or a set of ETF's that are include some that are highly correlated (0.7 and above).

Problem observed: I observe that if there are clusters of high correlations the distributions of eigenvalues I see do not seem to follow the "MP marchenko pastur" distribution that RMT talks about. Essentially the first few eigenvalues are incredibly "high" and dwarf all the others, if I exclude these first few then it starts to look somewhat like an MP distribution.

Questions: 1) Is RMT valid if high correlations are present, or does it presume "independnet" return series.

2) Is it necessary to remove the "market" component or drop the first few eigenvalues before performing the "cleaning" procedure?

3) In general is there any guidance on using covariance shrinkage vs RMT - which works best and when for the purposes of minimum variance optimization?

Thanks very much, this is a fantastic forum.

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3 Answers 3

up vote 7 down vote accepted

This is a misunderstanding of how to apply RMT theory.

The point of the MP distribution is to describe the expected distribution of eigenvalues assuming a symmetric matrix whose elements are drawn from a normal distribution of mean zero and some sigma. So if you observe eigenvalues beyond the level predicted by MP this means you have found factors that are non-random.

In fact, when applied to market data it is quite common to find several factors that are extraordinarily large vs. the upper noise band predicted by RMT.

Other questions:

  1. "Is RMT valid if high correlations present" -- answered above. Short answer - yes.

  2. Not n'ecy to remove the market component. And definitely do not remove the largest eigenvalues. The point is to preserve them and "cleanse" the remainder.

  3. Covariance shrinkage is compelling as well. You have to do you own empirical study to compare the two given the nature of the data. The downside with RMT is you have more parameters to deal with (exponential decay factor, cleansing the correlation matrix vs. the covariance matrix, parameter Q, etc.)

A fuller description of the RMT process is here.

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Regarding the optimization question: I haven't compared random matrix estimates to shrinkage estimates, but shrinkage seems to beat (statistical) factor models -- see a series of blog posts at http://www.portfolioprobe.com/tag/ledoit-wolf-shrinkage/

However, my guess is that random matrix estimates behave a lot like factor models, and hence that shrinkage is better. Note: my guesses have been wrong before.

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There seem to be natural clusters like different sectors/industries, so maybe you could make clusterization of the correlation matrix. This is a very interesting paper about sector rotation and clusterization of stock market time-series.

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