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19

The minimum variance solution loads up on securities that have low variances and co-variances. Theoretically you are correct that this should have a low expected return profile. However, it turns out - in contradiction to modern portfolio theory - that securities that have low-volatility or low-beta experience higher returns than high-volatility or ...


16

Yes, the weights of the first eigenvector of a covariance matrix represent the market factor and also the largest source of systematic risk (variation of returns). Why PCA? Well, PCA simply identifies the eigenvector that maximally explains the variance of the system. It turns out that this is the "market factor" - i.e. the tendency of securities to rise ...


13

Short of having a 'reasonable' predictive model for expected returns and the covariance matrix, there are a couple lines of attack. Shrinkage estimators (via Bayesian inference or Stein-class of estimators) Robust portfolio optimization Michaud's Resampled Efficient Frontier Imposing norm constraints on portfolio weights Naively, shrinkage methods ...


13

Statistically you would apply Bessel's correction to address the bias you point out. However, that misses the point that the variance-covariance matrix is non-stationary, suffers from the curse of dimensionality, and that the noisy mean return estimates have significantly more impact than a biased covariance matrix on portfolio weights. The best ways to ...


10

Both answers from Shane and Vishal Belsare make sense and detail different models. In my experience, I have never been satisfied by a unique model since the majority of papers out there can be split in two categories: Those that predict the mean component of the problem. Those that predict the variance component of the problem. The ideal (to read ...


8

The following papers may help. A New Look at Minimum Variance Investing by Bernd Scherer Minimum Variance Portfolio Composition by Clarke, De Silva & Thorley Under a multifactor risk-based model, if the global minimum variance portfolio dominates the market portfolio, the implication is that the market portfolio is not multifactor efficient and that ...


7

You raise a very important point, which unfortunately doesn't have a simple answer. Black-Litterman addresses the allocation problem by allowing you to provide a prior within a bayesian framework. It doesn't really tell you how to produce the prior itself. But more importantly, it doesn't address the fundamental problem: it's difficult to accurately ...


7

Yes. Check out the Lower Partial Moments literature. In my view the best introduction to this is Narwrocki - A Brief History of Downside Risk Measures. Uryasev established equivalence between CVaR approach and low partial moments. If Markowitz had the tools at the time time, LPM utility functions would be the introductory optimization model as opposed to ...


6

Unlike the tangency portfolio on the efficient frontier (which represents the most efficient portfolio in terms of max expected sharp ratio), min var portfolios have no ex ante theory that suggests it should outperform a cap weighted market portfolio. The same can be said about other risk-weighted portfolio construction schemes, including equal risk ...


6

If you look in the portfolio management sections of the CFA (chartered financial analyst) curriculum, you'll find a listing of commonly used portfolio management techniques. It is by no means exhaustive, but the content in the CFA curriculum comes directly from industry professionals, so it is reasonable current and applicable. CFA Candidate Body of ...


6

Bernd Scherer has done exactly this test in his text "Portfolio Construction and Risk Budgeting 4th Edition". There is an SSRN paper by Scherer called "Resampled Efficiency and Portfolio Choice (2004)" you can take a look at as well. I would suggest you skip re-sampling (especially if you have a long-only portfolio) and take a look at Meucci's Robot ...


6

This is indeed a subtle point. What is generally meant with this statement is that correlation is going up in bear markets, so it is not so much the "turmoil" part (i.e. volatility per se) but the "trend" (i.e. negative in this case) part. Putting it another way is that when you control for volatility not the correlation but the covariance (which is the part ...


5

I'm just providing a global answer to the question, as I think it can be interesting for some beginners in quant finance. The properties given by TheBridge: Normalize $\rho (\emptyset)=0$ This means you have no risk in taking no position. Sub-addiitivity $\rho(A_1+A_2) \leq \rho(A_1)+\rho(A_2)$ Having a position in two different can only decrease the ...


5

There are many portfolio optimization paradigms that include a preference for skewness. These are generally alternatives meant to replace the modern portfolio management mean-variance framework developed by Markowitz. Skewness (or, more generally, higher moments) are only relevant in portfolio optimization if (a) assets are not normally distributed, and ...


5

From a theoretical point of view (you mentioned beta, so assume we're in a CAPM world), you should hold the market portfolio (let's assume S&P500 index) and be long (or short) the risk-free asset to decrease (or increase) your return and risk. That is, if you'd like higher returns than the S&P500 offers and are willing to accept the risk, trade the ...


5

Tools from the field of stochastic optimization are best suited for these problems. In particular, attached is a paper on non-parametric density estimation for stochastic optimization that describes an algorithm if state variables can be associated with draws from the predictive distribution. Here's another approach by Kuhn. These are all one-period ...


5

The blog post http://www.portfolioprobe.com/2011/10/03/predictability-of-kurtosis-and-skewness-in-sp-constituents/ suggests that there is some predictability in kurtosis, but it isn't clear (to me at least) that there is enough predictabiilty to be useful. If there is a place for higher moments, my guess is that it is in asset allocation problems where ...


5

The minimum variance optimization framework does not guarantee positive return whatsoever. As a matter of fact what you are trying to do is something close to the following: $$\underset{w}{\arg \min} \quad w' Q w \quad \text{s.t} \quad Aw \leq b,\quad \sum_i w_i=1$$ The fact that you get positive return is a nice result that you get from your backtest ...


5

The given matrix can not represent a covariance matrix since it would imply that asset 1 is negatively correlated to asset 2 and asset 3. But asset 2 is negatively correlated to asset 3 which contradicts the first statement. In general a covariance matrix has to be positive semi-definite and symmetric, and conversely every positive semi-definite symmetric ...


5

Accurately stated: Diversification helps during turmoil, but helps less as what would be expected by using $w^T \Omega w$ as the portfolio variance where the off-diagonal covariances are estimated during tranquil periods. This is because correlations and covariances change during turmoil, typically increasing. This reduces the benefit of diversification ...


5

To clarify notation, you have an universe of $n=2000 \space$ stocks and two portfolio vectors $\mathbf{a},\mathbf{b}\in\mathbb{R}^{n}$ with $\left\|\mathbf{a}\right\|_{1}=\left\|\mathbf{b}\right\|_{1}=1$. Further, you have Estimators for the true Variance $\operatorname{Var}\left[\mathbf{a}\right]$ resp. $\operatorname{Var}\left[\mathbf{b}\right]$ and the ...


5

This optimization is trivial $$ w^{T,J}_i = \begin{cases} 1 \quad \text{if } i=\arg \max_i R^{T,J}(S_i) \\0 \quad \text{otherwise} \end{cases} $$ That is to say, when you optimize only one weight will be nonzero. That's because these ratios incorporate no notion of distributional width, and therefore do not reward diversification. With no concentration ...


5

The weak EMH states that it is impossible to earn an excess return given publicly known information such as past prices. Clearly, different securities have different expected returns. For example: the bond and the stock of one company or a security that generates twice the return of another one. This difference in expected return is explained by a ...


4

Yes, this is what the idea behind Omega as a portfolio optimization objective is all about. Keating and Shadwick (2002a, 2002b) first introduced this notion. An introduction by Keating is here. In fact, the Performance Analytics package in R includes a function to calculate Omega. For your second question, one can compute the moments of higher orders ...


4

Adding a bit to the references mentioned by Quant Guy - apart from the aforementioned paper by Keating and Shadwick, Kazemi et al. introduce an alternative formulation of the Omega ratio (Sharpe-Omega) similar to the Sharpe ratio. As noted by Patrick Burns, higher moments could have some use when instruments other than equity are involved (hedge fund ...


4

There's a huge literature on this topic going back at least 30 years, and I am unfortunately not familiar enough with this literature to give you a great answer to your specific question. However, I will in this answer at least try to point you in some useful directions according to what I've found thus far. Kurtosis, by the way, seems like it is not ...


4

the question is very broad, Here is the brief summary of the role of all moments in portfolio optimization: expected value- the 1st moment represents the reward. All the even higher moments represent the likelihood of extreme values. Larger values for these moments indicate greater uncertainty. The odd moments represent measures of asymmetry. Skewness ...


4

Most portfolio managers look at the Sharpe ratio, or occasionally the Treynor ratio. In general, you want to maximize one of the these metrics, though there could be other issues that you haven't currently considered, like turnover or transaction costs associated with obtaining the portfolio.


4

The unconstrained mean-variance problem $$w_{mv,unc}\equiv argmax\left\{ w'\mu-\frac{1}{2}\lambda w'\Sigma w\right\} $$ can easily be found by taking the derivative $$\frac{\partial}{\partial w}\left(w'\mu-\frac{1}{2}\lambda w'\Sigma w\right)=\mu-\lambda\Sigma w $$ setting it to zero, and solving for $w$. This gives ...


4

The initial investment is the capital in the account used to support the portfolio, not the cost of the assets in the portfolio. For example, when you sell a stock or bond short, your account doesn't actually accrue any cash. Instead you start receiving a regular cash flow. There isn't necessarily a difference between these quantities in a long-only ...



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