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Contribution Details

Type Working Paper
Scope Discipline-based scholarship
Title Risk reduction and efficiency increase in large portfolios: leverage and shrinkage
Organization Unit
  • Zhao Zhao
  • Olivier Ledoit
  • Hui Jiang
  • English
Institution University of Zurich
Series Name Working paper series / Department of Economics
Number 328
ISSN 1664-705X
Number of Pages 33
Date 2020
Abstract Text We investigate the effects of constraining leverage and shrinking covariance matrix in constructing large portfolios, both theoretically and empirically. Considering a wide variety of setups that involve conditioning or not conditioning the covariance matrix estimator on the recent past (multivariate GARCH), smaller vs. larger universe of stocks, alternative portfolio formation objectives (Global Minimum Variance vs. exposure to profitable factors), and various transaction cost assumptions, we find that a judiciously-chosen shrinkage method always outperforms an arbitrarily-determined leverage constraint. By extending the mathematical connection between leverage and shrinkage from static to dynamic, we provide a new theoretical explanation for our finding from the perspective of degrees of freedom. In addition, both simulation and empirical analysis show that the DCC-NL estimator results in risk reduction and efficiency increase in large portfolios as long as a small amount of leverage is allowed, whereas tightening the leverage constraint often hurts a DCC-NL portfolio.
Other Identification Number merlin-id:18371
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Keywords DCC, nonlinear shrinkage, leverage constraint, large portfolios, risk reduction, Markowitz mean-variance efficiency, multivariate GARCH, Investitionsrisiko, Optimierungsproblem, Leverage-Effekt, Baisse-Spekulation, Portfolio Selection
Additional Information Revised version