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Optimal Asset Allocation with Factor Models for Large Portfolios

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Author Info
Pesaran, M.H.
Zaffaroni, P.

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Abstract

This paper characterizes the asymptotic behaviour, as the number of assets gets arbitrarily large, of the portfolio weights for the class of tangency portfolios belonging to the Markowitz paradigm. It is as- sumed that the joint distribution of asset returns is characterized by a general factor model, with possibly heteroskedastic components. Under these conditions, we establish that a set of appealing properties, so far unnoticed, characterize traditional Markowitz portfolio trading strategies. First, we show that the tangency portfolios fully diversify the risk associated with the factor component of asset return innovations. Second, with respect to determination of the portfolio weights, the conditional distribution of the factors is of second-order importance as compared to the distribution of the factor loadings and that of the idiosyncratic components. Third, although of crucial importance in forecasting asset returns, current and lagged factors do not enter the limit portfolio returns. Our theoretical results also shed light on a number of issues discussed in the literature regarding the limiting properties of portfolio weights such as the diversi¯ability property and the number of dominant factors.

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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0813.

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Length: 24
Date of creation: Mar 2008
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Handle: RePEc:cam:camdae:0813

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Related research
Keywords: Asset allocation; Large Porftolios; Factor models; Diversi¯cation.;

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Find related papers by JEL classification:
C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions
C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation and Testing
C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Other Model Applications
G1 - Financial Economics - - General Financial Markets

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  6. Grinblatt, Mark & Titman, Sheridan, 1987. "The Relation between Mean-Variance Efficiency and Arbitrage Pricing," Journal of Business, University of Chicago Press, vol. 60(1), pages 97-112, January. [Downloadable!] (restricted)
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  14. Diebold, Francis X & Nerlove, Marc, 1989. "The Dynamics of Exchange Rate Volatility: A Multivariate Latent Factor Arch Model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 4(1), pages 1-21, Jan.-Mar.. [Downloadable!] (restricted)
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  15. Ross, Stephen A., 1976. "The arbitrage theory of capital asset pricing," Journal of Economic Theory, Elsevier, vol. 13(3), pages 341-360, December. [Downloadable!] (restricted)
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  17. Kandel, Shmuel & Stambaugh, Robert F, 1996. " On the Predictability of Stock Returns: An Asset-Allocation Perspective," Journal of Finance, American Finance Association, vol. 51(2), pages 385-424, June. [Downloadable!] (restricted)
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  18. Connor, Gregory & Korajczyk, Robert A. & Linton, Oliver, 2006. "The common and specific components of dynamic volatility," Journal of Econometrics, Elsevier, vol. 132(1), pages 231-255, May. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Jianqing Fan & Jingjin Zhang & Ke Yu, 2008. "Asset Allocation and Risk Assessment with Gross Exposure Constraints for Vast Portfolios," Quantitative Finance Papers 0812.2604, arXiv.org. [Downloadable!]
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