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Dynamic portfolio selection with sector-specific regularization

Author

Listed:
  • Hafner, Christian

    (Université catholique de Louvain, LIDAM/ISBA, Belgium)

  • Wang, Linqi

    (Université catholique de Louvain, LIDAM/LFIN, Belgium)

Abstract

This paper proposes a new algorithm for dynamic portfolio selection that takes a sector structure into account. We consider regularization with respect to within and between sector variation of portfolio weights, additional to sparsity and trans- action cost controls. Our model includes two special cases as benchmarks: a dy- namic conditional correlation model with shrinkage estimation of the unconditional covariance matrix, and the equally weighted portfolio. We propose an algorithm for estimation of the model parameters and calibration of the penalty terms based on cross-validation. In an empirical study, we find that the within-sector penalty has by far the highest contribution to the reduction of out-of-sample volatility of portfolio returns. Our model improves both the pure DCC with shrinkage and the equally-weighted portfolio out-of-sample.

Suggested Citation

  • Hafner, Christian & Wang, Linqi, 2020. "Dynamic portfolio selection with sector-specific regularization," LIDAM Discussion Papers ISBA 2020032, Université catholique de Louvain, Institute of Statistics, Biostatistics and Actuarial Sciences (ISBA).
  • Handle: RePEc:aiz:louvad:2020032
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    References listed on IDEAS

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    5. Jianqing Fan & Alex Furger & Dacheng Xiu, 2016. "Incorporating Global Industrial Classification Standard Into Portfolio Allocation: A Simple Factor-Based Large Covariance Matrix Estimator With High-Frequency Data," Journal of Business & Economic Statistics, Taylor & Francis Journals, vol. 34(4), pages 489-503, October.
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    More about this item

    Keywords

    dynamic conditional correlation; cross-validation; shrinkage; industry sectors;
    All these keywords.

    JEL classification:

    • C14 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Semiparametric and Nonparametric Methods: General
    • C43 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: Special Topics - - - Index Numbers and Aggregation
    • Z11 - Other Special Topics - - Cultural Economics - - - Economics of the Arts and Literature

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