Arbeitspapier

Risk reduction and efficiency increase in large portfolios: Leverage and shrinkage

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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.

Language: Englisch

Bibliographic citation: Series: Working Paper ; No. 328

Classification: Wirtschaft
Estimation: General
Financial Econometrics
Portfolio Choice; Investment Decisions

Subject: DCC
Nonlinear shrinkage
Leverage constraint
Large portfolios
Risk reduction
Markowitz mean-variance efficiency

Event: Geistige Schöpfung

(who): Zhao, Zhao
Ledoit, Olivier
Jiang, Hui

Event: Veröffentlichung

(who): University of Zurich, Department of Economics

(where): Zurich

(when): 2020

DOI: doi:10.5167/uzh-172206

Handle: http://hdl.handle.net/10419/213444

Last update: 10.03.2025, 11:43 AM CET

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Object type

Arbeitspapier

Associated

Zhao, Zhao
Ledoit, Olivier
Jiang, Hui
University of Zurich, Department of Economics

Time of origin

2020

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