IDEAS home Printed from https://ideas.repec.org/a/bla/mathfi/v31y2021i4p1162-1189.html
   My bibliography  Save this article

Risk‐sensitive benchmarked asset management with expert forecasts

Author

Listed:
  • Mark H.A. Davis
  • Sébastien Lleo

Abstract

We propose a continuous‐time model in which investors use expert forecasts to construct a benchmark‐outperforming portfolio in two steps. The estimation step takes the form of a Kalman filter. The control step derives the optimal investment policy in closed form and establishes that the value function is the unique classical solution to the Hamilton‐Jacobi‐Bellman partial differential equation. We show that the optimal investment policy generates a continuum of investment strategies, from passive benchmark replication to fully active bets in the Kelly portfolio. However, our model warns against over‐betting on financial markets. Moreover, we find that the Kelly portfolio performs both security selection and factor tilt. A simulation study with market data confirms that factor choice is critical at every stage of the investment process. Finally, debiasing is equally crucial. Portfolios with debiased expert forecasts outperform portfolios with biased forecasts.

Suggested Citation

  • Mark H.A. Davis & Sébastien Lleo, 2021. "Risk‐sensitive benchmarked asset management with expert forecasts," Mathematical Finance, Wiley Blackwell, vol. 31(4), pages 1162-1189, October.
    • Handle: RePEc:bla:mathfi:v:31:y:2021:i:4:p:1162-1189
    DOI: 10.1111/mafi.12310
    as

    Download full text from publisher

    File URL: https://doi.org/10.1111/mafi.12310
    Download Restriction: no
    File URL: https://libkey.io/10.1111/mafi.12310?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. Guanhao Feng & Stefano Giglio & Dacheng Xiu, 2019. "Taming the Factor Zoo: A Test of New Factors," NBER Working Papers 25481, National Bureau of Economic Research, Inc.
    2. Mark H. A. Davis & Sébastien Lleo, 2014. "Risk-Sensitive Asset Management," World Scientific Book Chapters, in: RISK-SENSITIVE INVESTMENT MANAGEMENT, chapter 2, pages 17-40, World Scientific Publishing Co. Pte. Ltd..
    3. Mark H A Davis & Sébastien Lleo, 2014. "Risk-Sensitive Investment Management," World Scientific Books, World Scientific Publishing Co. Pte. Ltd., number 9026.
    4. Rüdiger Frey & Abdelali Gabih & Ralf Wunderlich, 2012. "Portfolio Optimization Under Partial Information With Expert Opinions," World Scientific Book Chapters, in: Matheus R Grasselli & Lane P Hughston (ed.), Finance at Fields, chapter 11, pages 265-282, World Scientific Publishing Co. Pte. Ltd..
    5. Eckhard Platen, 2006. "A Benchmark Approach To Finance," Mathematical Finance, Wiley Blackwell, vol. 16(1), pages 131-151, January.
    6. Eckhard Platen & Wolfgang Runggaldier, 2004. "A Benchmark Approach to Filtering in Finance," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 11(1), pages 79-105, March.
    7. Jörn Sass & Dorothee Westphal & Ralf Wunderlich, 2017. "Expert Opinions And Logarithmic Utility Maximization For Multivariate Stock Returns With Gaussian Drift," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 20(04), pages 1-41, June.
    8. John H. Cochrane, 2011. "Presidential Address: Discount Rates," Journal of Finance, American Finance Association, vol. 66(4), pages 1047-1108, August.
    9. Eckhard Platen & Wolfgang Runggaldier, 2007. "A Benchmark Approach to Portfolio Optimization under Partial Information," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 14(1), pages 25-43, March.
    10. Mark Davis & SEBastien Lleo, 2008. "Risk-sensitive benchmarked asset management," Quantitative Finance, Taylor & Francis Journals, vol. 8(4), pages 415-426.
    11. Merton, Robert C, 1969. "Lifetime Portfolio Selection under Uncertainty: The Continuous-Time Case," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 247-257, August.
    12. Abdelali Gabih & Hakam Kondakji & Jorn Sass & Ralf Wunderlich, 2014. "Expert Opinions and Logarithmic Utility Maximization in a Market with Gaussian Drift," Papers 1402.6313, arXiv.org.
    13. Rudiger Frey & Abdelali Gabih & Ralf Wunderlich, 2013. "Portfolio Optimization under Partial Information with Expert Opinions: a Dynamic Programming Approach," Papers 1303.2513, arXiv.org, revised Feb 2014.
    14. Fama, Eugene F. & French, Kenneth R., 2015. "A five-factor asset pricing model," Journal of Financial Economics, Elsevier, vol. 116(1), pages 1-22.
    15. Ang, Andrew, 2014. "Asset Management: A Systematic Approach to Factor Investing," OUP Catalogue, Oxford University Press, number 9780199959327, Decembrie.
    16. Victor DeMiguel & Alberto Martín-Utrera & Francisco J Nogales & Raman Uppal & Andrew KarolyiEditor, 2020. "A Transaction-Cost Perspective on the Multitude of Firm Characteristics," Review of Financial Studies, Society for Financial Studies, vol. 33(5), pages 2180-2222.
    17. Dirk Becherer, 2001. "The numeraire portfolio for unbounded semimartingales," Finance and Stochastics, Springer, vol. 5(3), pages 327-341.
    18. Davis, Mark & Lleo, Sébastien, 2020. "Debiased expert forecasts in continuous-time asset allocation," Journal of Banking & Finance, Elsevier, vol. 113(C).
    19. Guanhao Feng & Stefano Giglio & Dacheng Xiu, 2020. "Taming the Factor Zoo: A Test of New Factors," Journal of Finance, American Finance Association, vol. 75(3), pages 1327-1370, June.
    20. Carhart, Mark M, 1997. "On Persistence in Mutual Fund Performance," Journal of Finance, American Finance Association, vol. 52(1), pages 57-82, March.
    21. Long, John Jr., 1990. "The numeraire portfolio," Journal of Financial Economics, Elsevier, vol. 26(1), pages 29-69, July.
    22. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    23. Rüdiger Frey & Abdelali Gabih & Ralf Wunderlich, 2012. "Portfolio Optimization Under Partial Information With Expert Opinions," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 15(01), pages 1-18.
    24. Treynor, Jack L & Black, Fischer, 1973. "How to Use Security Analysis to Improve Portfolio Selection," The Journal of Business, University of Chicago Press, vol. 46(1), pages 66-86, January.
    25. Sid Browne, 1997. "Survival and Growth with a Liability: Optimal Portfolio Strategies in Continuous Time," Mathematics of Operations Research, INFORMS, vol. 22(2), pages 468-493, May.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Jan Obłój & Thaleia Zariphopoulou, 2021. "In memoriam: Mark H. A. Davis and his contributions to mathematical finance," Mathematical Finance, Wiley Blackwell, vol. 31(4), pages 1099-1110, October.
    2. Kexin Chen & Hoi Ying Wong, 2022. "Duality in optimal consumption--investment problems with alternative data," Papers 2210.08422, arXiv.org, revised Jul 2023.
    3. Marcin Pitera & {L}ukasz Stettner, 2022. "Discrete-time risk sensitive portfolio optimization with proportional transaction costs," Papers 2201.02828, arXiv.org.
    4. S'ebastien Lleo & Wolfgang J. Runggaldier, 2023. "On the Separation of Estimation and Control in Risk-Sensitive Investment Problems under Incomplete Observation," Papers 2304.08910, arXiv.org, revised Nov 2023.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. S'ebastien Lleo & Wolfgang J. Runggaldier, 2023. "On the Separation of Estimation and Control in Risk-Sensitive Investment Problems under Incomplete Observation," Papers 2304.08910, arXiv.org, revised Nov 2023.
    2. Abdelali Gabih & Hakam Kondakji & Ralf Wunderlich, 2018. "Asymptotic Filter Behavior for High-Frequency Expert Opinions in a Market with Gaussian Drift," Papers 1812.03453, arXiv.org, revised Mar 2020.
    3. Söhnke M. Bartram & Harald Lohre & Peter F. Pope & Ananthalakshmi Ranganathan, 2021. "Navigating the factor zoo around the world: an institutional investor perspective," Journal of Business Economics, Springer, vol. 91(5), pages 655-703, July.
    4. Ke Du & Eckhard Platen, 2011. "Three-Benchmarked Risk Minimization for Jump Diffusion Markets," Research Paper Series 296, Quantitative Finance Research Centre, University of Technology, Sydney.
    5. Borup, Daniel, 2019. "Asset pricing model uncertainty," Journal of Empirical Finance, Elsevier, vol. 54(C), pages 166-189.
    6. Solène Collot & Tobias Hemauer, 2021. "A literature review of new methods in empirical asset pricing: omitted-variable and errors-in-variable bias," Financial Markets and Portfolio Management, Springer;Swiss Society for Financial Market Research, vol. 35(1), pages 77-100, March.
    7. Bakalli, Gaetan & Guerrier, Stéphane & Scaillet, Olivier, 2023. "A penalized two-pass regression to predict stock returns with time-varying risk premia," Journal of Econometrics, Elsevier, vol. 237(2).
    8. Obaid, Khaled & Pukthuanthong, Kuntara, 2022. "A picture is worth a thousand words: Measuring investor sentiment by combining machine learning and photos from news," Journal of Financial Economics, Elsevier, vol. 144(1), pages 273-297.
    9. Cujean, Julien & Andrei, Daniel & Fournier, Mathieu, 2019. "The Low-Minus-High Portfolio and the Factor Zoo," CEPR Discussion Papers 14153, C.E.P.R. Discussion Papers.
    10. Lin, Qi, 2022. "Understanding idiosyncratic momentum in the Chinese stock market," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 76(C).
    11. Calvet, Laurent E. & Betermier, Sebastien & Jo, Evan, 2019. "A Supply and Demand Approach to Equity Pricing," CEPR Discussion Papers 13974, C.E.P.R. Discussion Papers.
    12. Abdelali Gabih & Hakam Kondakji & Ralf Wunderlich, 2022. "Well Posedness of Utility Maximization Problems Under Partial Information in a Market with Gaussian Drift," Papers 2205.08614, arXiv.org, revised Feb 2024.
    13. Gagliardini, Patrick & Ossola, Elisa & Scaillet, Olivier, 2019. "Estimation of large dimensional conditional factor models in finance," Working Papers unige:125031, University of Geneva, Geneva School of Economics and Management.
    14. Pablo Solórzano-Taborga & Ana Belén Alonso-Conde & Javier Rojo-Suárez, 2020. "Data Envelopment Analysis and Multifactor Asset Pricing Models," IJFS, MDPI, vol. 8(2), pages 1-18, April.
    15. Gabriele D'Acunto & Paolo Bajardi & Francesco Bonchi & Gianmarco De Francisci Morales, 2021. "The Evolving Causal Structure of Equity Risk Factors," Papers 2111.05072, arXiv.org.
    16. Davis, Mark & Lleo, Sébastien, 2020. "Debiased expert forecasts in continuous-time asset allocation," Journal of Banking & Finance, Elsevier, vol. 113(C).
    17. Vafai, Nima & Rakowski, David, 2024. "The sources of portfolio volatility and mutual fund performance," International Review of Financial Analysis, Elsevier, vol. 91(C).
    18. Alexander M. Chinco & Samuel M. Hartzmark & Abigail B. Sussman, 2020. "Necessary Evidence For A Risk Factor’s Relevance," NBER Working Papers 27227, National Bureau of Economic Research, Inc.
    19. Sun, Yang & Zhang, Xuan & Zhang, Zhekai, 2022. "The reduced-rank beta in linear stochastic discount factor models," International Review of Financial Analysis, Elsevier, vol. 84(C).
    20. Carter Davis, 2023. "The Elasticity of Quantitative Investment," Papers 2303.14533, arXiv.org.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:bla:mathfi:v:31:y:2021:i:4:p:1162-1189. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Wiley-Blackwell Digital Licensing or Christopher F. Baum (email available below). General contact details of provider: http://www.blackwellpublishing.com/journal.asp?ref=0960-1627 .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.