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Indirect and direct forecasting of volatility-timing portfolios

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  • Xie, Xiaodu

Abstract

Recent studies have challenged the usefulness of variance–covariance matrix forecasting for the purpose of minimum-variance portfolio construction, instead advocating for the direct forecasting of realized weights. This study examines the value of this direct approach when dimension reduction is handled in the portfolio construction problem via popular volatility timing strategies. Using empirical data from the 45 largest U.S. stocks, this paper reveals that the traditional indirect approach, which relies on volatility forecasts, consistently delivers higher out-of-sample portfolio Sharpe ratios. This finding is robust to random portfolio selection, forecasting horizons, and transaction costs. The results demonstrate the continued usefulness of volatility forecasting models in portfolio construction.

Suggested Citation

  • Xie, Xiaodu, 2025. "Indirect and direct forecasting of volatility-timing portfolios," Economics Letters, Elsevier, vol. 247(C).
    • Handle: RePEc:eee:ecolet:v:247:y:2025:i:c:s0165176524006268
    DOI: 10.1016/j.econlet.2024.112142
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    References listed on IDEAS

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    JEL classification:

    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics
    • G17 - Financial Economics - - General Financial Markets - - - Financial Forecasting and Simulation
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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