The Impact of Covariance Misspecification in Risk-Based Portfolios

17 Pages Posted: 28 Aug 2015 Last revised: 15 Nov 2017

See all articles by David Ardia

David Ardia

HEC Montreal - Department of Decision Sciences

Guido Bolliger

University of Neuchatel - Institute of Financial Analysis

Kris Boudt

Ghent University; Vrije Universiteit Brussel; Vrije Universiteit Amsterdam

Jean-Philippe Gagnon Fleury

Université Laval - Département de Finance et Assurance

Date Written: November 17, 2015

Abstract

The equal-risk-contribution, inverse-volatility weighted, maximum-diversification and minimum-variance portfolio weights are all direct functions of the estimated covariance matrix. We perform a Monte Carlo study to assess the impact of covariance matrix misspecification to these risk-based portfolios. Our results show that the equal-risk-contribution and inverse-volatility weighted portfolio weights are relatively robust to covariance misspecification, but that the minimum-variance and maximum-diversification portfolios are highly sensitive to errors in the estimated variance and correlation, respectively.

Keywords: Covariance misspecification, Monte Carlo study, Risk-based portfolios

JEL Classification: C13, C15, C22, C53

Suggested Citation

Ardia, David and Bolliger, Guido and Boudt, Kris and Gagnon Fleury, Jean-Philippe, The Impact of Covariance Misspecification in Risk-Based Portfolios (November 17, 2015). Annals of Operation Research, Vol. 254, No. 1, pp. 1-16, 2017. Available at SSRN: https://ssrn.com/abstract=2650644 or http://dx.doi.org/10.2139/ssrn.2650644

David Ardia (Contact Author)

HEC Montreal - Department of Decision Sciences ( email )

3000 Côte-Sainte-Catherine Road
Montreal, QC H2S1L4
Canada

Guido Bolliger

University of Neuchatel - Institute of Financial Analysis ( email )

Rue A.-L. Breguet 2
Neuchatel, CH-2000
Switzerland
+41327226103 (Phone)

Kris Boudt

Ghent University ( email )

Sint-Pietersplein 5
Gent, 9000
Belgium

Vrije Universiteit Brussel ( email )

Pleinlaan 2
http://www.vub.ac.be/
Brussels, 1050
Belgium

Vrije Universiteit Amsterdam ( email )

De Boelelaan 1105
Amsterdam, ND North Holland 1081 HV
Netherlands

Jean-Philippe Gagnon Fleury

Université Laval - Département de Finance et Assurance ( email )

Pavillon Palasis-Prince
Quebec G1K 7P4
Canada

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