Disentangling the role of variance and covariance information in portfolio selection problems |
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Authors: | André A. P. Santos |
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Affiliation: | 1. Department of Economics, Universidade Federal de Santa Catarina , Campus Reitor Jo?o David Ferreira Lima, Trindade, Florianópolis, Santa Catarina, 88040-900 Brazil.andre.portela@ufsc.br |
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Abstract: | The covariation among financial asset returns is often a key ingredient used in the construction of optimal portfolios. Estimating covariances from data, however, is challenging due to the potential influence of estimation error, specially in high-dimensional problems, which can impact negatively the performance of the resulting portfolios. We address this question by putting forward a simple approach to disentangle the role of variance and covariance information in the case of mean-variance efficient portfolios. Specifically, mean-variance portfolios can be represented as a two-fund rule: one fund is a fully invested portfolio that depends on diagonal covariance elements, whereas the other is a long-short, self financed portfolio associated with the presence of non-zero off-diagonal covariance elements. We characterize the contribution of each of these two components to the overall performance in terms of out-of-sample returns, risk, risk-adjusted returns and turnover. Finally, we provide an empirical illustration of the proposed portfolio decomposition using both simulated and real market data. |
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Keywords: | Inverse covariance matrix Minimum variance portfolio Reward-to-risk timing Tangency portfolio Volatility timing |
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