The Impact of Estimation Error on Latent Factor Model Forecasts of Portfolio Risk

Posted: 26 Jun 2016 Last revised: 22 May 2019

See all articles by Stephen Bianchi

Stephen Bianchi

University of California, Berkeley

Lisa R. Goldberg

University of California, Berkeley; Aperio Group

Allan Rosenberg

State Steet Global Exchange

Date Written: June 24, 2016

Abstract

In this article, the authors measure the impact of estimation error on latent factor model forecasts of portfolio risk and factor exposures. In markets simulated with a Gaussian return generating process, the authors measure errors in forecasts for equally weighted and long-only minimum variance portfolios constructed from a universe of 500 securities. They find that an estimation period of 250 days may be adequate to accurately forecast risk and factor exposures for an equally weighted portfolio. In contrast, the risk of a long-only minimum variance portfolio is substantially under-forecast even with an estimation period of 1000 days. This underscores the importance of testing risk models on optimized portfolios.

Keywords: estimation error, latent factor model, simulation, minimum variance portfolio, equally weighted portfolio, underforecast

JEL Classification: G10

Suggested Citation

Bianchi, Stephen and Goldberg, Lisa R. and Rosenberg, Allan, The Impact of Estimation Error on Latent Factor Model Forecasts of Portfolio Risk (June 24, 2016). Journal of Portfolio Management, Forthcoming, https://doi.org/10.3905/jpm.2017.43.5.147, Available at SSRN: https://ssrn.com/abstract=2800410

Stephen Bianchi

University of California, Berkeley ( email )

530 Evans Hall
MC #3880
Berkeley, CA 94720
United States

Lisa R. Goldberg (Contact Author)

University of California, Berkeley ( email )

Department of Statistics
367 Evans Hall
Berkeley, CA 94720-3860
United States

Aperio Group ( email )

3 Harbor Drive
Suite 315
Sausalito, CA 94965
United States

Allan Rosenberg

State Steet Global Exchange ( email )

255 California Street
Suite 1201
San Francisco, CA 94105
United States

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