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Portfolio Optimization Using a Consistent Vector-Based MSE Estimation Approach

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  • Maaz Mahadi
  • Tarig Ballal
  • Muhammad Moinuddin
  • Tareq Y. Al-Naffouri
  • Ubaid Al-Saggaf

Abstract

This paper is concerned with optimizing the global minimum-variance portfolio's (GMVP) weights in high-dimensional settings where both observation and population dimensions grow at a bounded ratio. Optimizing the GMVP weights is highly influenced by the data covariance matrix estimation. In a high-dimensional setting, it is well known that the sample covariance matrix is not a proper estimator of the true covariance matrix since it is not invertible when we have fewer observations than the data dimension. Even with more observations, the sample covariance matrix may not be well-conditioned. This paper determines the GMVP weights based on a regularized covariance matrix estimator to overcome the aforementioned difficulties. Unlike other methods, the proper selection of the regularization parameter is achieved by minimizing the mean-squared error of an estimate of the noise vector that accounts for the uncertainty in the data mean estimation. Using random-matrix-theory tools, we derive a consistent estimator of the achievable mean-squared error that allows us to find the optimal regularization parameter using a simple line search. Simulation results demonstrate the effectiveness of the proposed method when the data dimension is larger than the number of data samples or of the same order.

Suggested Citation

  • Maaz Mahadi & Tarig Ballal & Muhammad Moinuddin & Tareq Y. Al-Naffouri & Ubaid Al-Saggaf, 2022. "Portfolio Optimization Using a Consistent Vector-Based MSE Estimation Approach," Papers 2204.05611, arXiv.org.
  • Handle: RePEc:arx:papers:2204.05611
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    References listed on IDEAS

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    3. Taras Bodnar & Solomiia Dmytriv & Nestor Parolya & Wolfgang Schmid, 2017. "Tests for the weights of the global minimum variance portfolio in a high-dimensional setting," Papers 1710.09587, arXiv.org, revised Jul 2019.
    4. Cai, T. Tony & Hu, Jianchang & Li, Yingying & Zheng, Xinghua, 2020. "High-dimensional minimum variance portfolio estimation based on high-frequency data," Journal of Econometrics, Elsevier, vol. 214(2), pages 482-494.
    5. Liusha Yang & Romain Couillet & Matthew R. McKay, 2015. "A Robust Statistics Approach to Minimum Variance Portfolio Optimization," Papers 1503.08013, arXiv.org.
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