Creating Investment Scheme with State Space Modeling

This paper proposes a unified approach to creating investment strategies with various desirable properties for investors. Particularly, we provide a new interpretation and the resulting formulations for state space models to attain our investment objectives, which are possibly specified as generating additional returns over benchmark stock indexes or achieving target risk-adjusted returns. Our state space models with particle filtering algorithm are employed to develop expert systems for investment strategies in highly complex financial markets. More concretely, in our state space framework, we apply a system model to representing portfolio weight processes with various constraints, as well as the standard underlying state variables such as volatility processes. Further, we formulate an observation model to stand for target value processes with non-linear functions of observed and latent variables. Numerical experiments demonstrate the effectiveness of our methodology through creating excess returns over S&P 500 and generating investment portfolios with fine risk-return profiles.