Sampling Error and Double Shrinkage Estimation of Minimum Variance Portfolios
AbstractShrinkage estimators of the covariance matrix are known to improve the stability over time of the Global Minimum Variance Portfolio (GMVP), as they are less error-prone. However, the improvement over the empirical covariance matrix is not optimal for small values of n, the estimation sample size. For typical asset allocation problems, with n small, this paper aims to introduce a new framework useful to improve the stability of the GMVP based on shrinkage estimators of the covariance matrix. First, we show analytically that the weights of any GMVP can be shrunk - within the framework of the ridge regression - towards the ones of the equally-weighted portfolio in order to reduce sampling error. Second, montecarlo simulations and empirical applications show that applying our methodology to the GMVP based on shrinkage estimators of the covariance matrix, leads to more stable portfolio weights, sharp decreases in portfolio turnovers, and often statistically lower (resp. higher) out-of-sample variances (resp. sharpe ratios). These results illustrate that double shrinkage estimation of the GMVP can be beneficial for realistic small estimation sample sizes.
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Bibliographic InfoPaper provided by Maastricht : METEOR, Maastricht Research School of Economics of Technology and Organization in its series Research Memoranda with number 002.
Date of creation: 2011
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Web page: http://www.maastrichtuniversity.nl/web/UMPublications.htm
monetary economics ;
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- Candelon Bertrand & Hurlin Christophe & Tokpavi Sessi, 2011. "Sampling Error and Double Shrinkage Estimation of Minimum Variance Portfolios," Research Memorandum 002, Maastricht University, Maastricht Research School of Economics of Technology and Organization (METEOR).
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- Bertrand Maillet & Sessi Tokpavi & Benoit Vaucher, 2013. "Minimum Variance Portfolio Optimisation under Parameter Uncertainty: A Robust Control Approach," EconomiX Working Papers 2013-28, University of Paris West - Nanterre la Défense, EconomiX.
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