The Impact of Covariance Misspecification in Risk-Based Portfolios
17 Pages Posted: 28 Aug 2015 Last revised: 15 Nov 2017
Date Written: November 17, 2015
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: Suggested Citation