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Contribution Details

Type Journal Article
Scope Discipline-based scholarship
Title Factor models for portfolio selection in large dimensions: the good, the better and the ugly
Organization Unit
Authors
  • Gianluca De Nard
  • Olivier Ledoit
  • Michael Wolf
Item Subtype Original Work
Refereed Yes
Status Published in final form
Language
  • English
Journal Title Journal of Financial Econometrics
Publisher Oxford University Press
Geographical Reach international
ISSN 1479-8409
Volume 19
Number 2
Page Range 236 - 257
Date 2021
Abstract Text This paper injects factor structure into the estimation of time-varying, large-dimensional covariance matrices of stock returns. Existing factor models struggle to model the covariance matrix of residuals in the presence of time-varying conditional heteroskedasticity in large universes. Conversely, rotation-equivariant estimators of large-dimensional time-varying covariance matrices forsake directional information embedded in market-wide risk factors. We introduce a new covariance matrix estimator that blends factor structure with time-varying conditional heteroskedasticity of residuals in large dimensions up to 1000 stocks. It displays superior all-around performance on historical data against a variety of state-of-the-art competitors, including static factor models, exogenous factor models, sparsity-based models, and structure-free dynamic models. This new estimator can be used to deliver more efficient portfolio selection and detection of anomalies in the cross-section of stock returns.
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Digital Object Identifier 10.1093/jjfinec/nby033
Other Identification Number merlin-id:18973
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Keywords Economics and Econometrics, Finance
Additional Information This is a pre-copy-editing, author-produced PDF of an article accepted for publication in Journal of Financial Econometrics following peer review. The definitive publisher-authenticated version "De Nard, Gianluca; Ledoit, Olivier; Wolf, Michael (2019). Factor models for portfolio selection in large dimensions: the good, the better and the ugly. Journal of Financial Econometrics, nby033" is available online at: dx.doi.org/10.1093/jjfinec/nby033