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When “time varying” volatility meets “transaction cost” in portfolio selection

Author

Listed:
  • Qiao, W.
  • Bu, D.
  • Gibberd, A.
  • Liao, Y.
  • Wen, T.
  • Li, E.

Abstract

We propose a new strategy for mean–variance portfolio selection that tackles transaction costs and change detection in covariance matrix simultaneously. The new strategy solely rebalances the portfolio when change points are detected in the covariance matrix, striking an optimal trade-off between rebalancing the portfolio to capturing the recent information in return data and avoiding excessive trading. Our empirical results suggest favorable out-of-sample performance of the new strategy in terms of portfolio variance, portfolio turnovers and portfolio sharpe ratio with transaction cost. We also show that these gains come from the improved accuracy for covariance matrix prediction and the ability for tracking significant changes in covariance matrix.

Suggested Citation

  • Qiao, W. & Bu, D. & Gibberd, A. & Liao, Y. & Wen, T. & Li, E., 2023. "When “time varying” volatility meets “transaction cost” in portfolio selection," Journal of Empirical Finance, Elsevier, vol. 73(C), pages 220-237.
    • Handle: RePEc:eee:empfin:v:73:y:2023:i:c:p:220-237
    DOI: 10.1016/j.jempfin.2023.06.006
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    References listed on IDEAS

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    More about this item

    Keywords

    Covariance matrix; Structural change; Transaction cost; Sparse time variation; Large scale portfolio;
    All these keywords.

    JEL classification:

    • C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Estimation: General
    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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