Incorporating Global Industrial Classification Standard into Portfolio Allocation: A Simple Factor-Based Large Covariance Matrix Estimator with High Frequency Data

34 Pages Posted: 13 Jan 2015 Last revised: 22 Apr 2015

See all articles by Jianqing Fan

Jianqing Fan

Princeton University - Bendheim Center for Finance

Alex Furger

Princeton University

Dacheng Xiu

University of Chicago - Booth School of Business

Date Written: April 21, 2015

Abstract

We document a striking block-diagonal pattern in the factor model residual covariances of the S&P 500 Equity Index constituents, after sorting the assets by their assigned Global Industry Classification Standard (GICS) codes. Cognizant of this structure, we propose combining a location-based thresholding approach based on sector inclusion with the Fama-French and SDPR sector Exchange Traded Funds (ETF’s).

We investigate the performance of our estimators in an out-of-sample portfolio allocation study. We find that our simple and positive-definite covariance matrix estimator yields strong empirical results under a variety of factor models and thresholding schemes. Conversely, we find that the Fama-French factor model is only suitable for covariance estimation when used in conjunction with our proposed thresholding technique. Theoretically, we provide justification for the empirical results by jointly analyzing the in-fill and diverging dimension asymptotics.

Keywords: big data, high-frequency factor model, GICS, location-based thresholding, low rank plus sparse, precision matrix, positive-definite, concentration inequality, SDPR sector ETF’s

Suggested Citation

Fan, Jianqing and Furger, Alex and Xiu, Dacheng, Incorporating Global Industrial Classification Standard into Portfolio Allocation: A Simple Factor-Based Large Covariance Matrix Estimator with High Frequency Data (April 21, 2015). Chicago Booth Research Paper No. 15-01. Available at SSRN: https://ssrn.com/abstract=2548613 or http://dx.doi.org/10.2139/ssrn.2548613

Jianqing Fan

Princeton University - Bendheim Center for Finance ( email )

26 Prospect Avenue
Princeton, NJ 08540
United States
609-258-7924 (Phone)
609-258-8551 (Fax)

HOME PAGE: http://orfe.princeton.edu/~jqfan/

Alex Furger

Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544-0708
United States

Dacheng Xiu (Contact Author)

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States

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