Optimal Portfolio Diversification via Independent Component Analysis

46 Pages Posted: 9 Dec 2018 Last revised: 29 Jan 2020

See all articles by Nathan Lassance

Nathan Lassance

UCLouvain - UCLouvain, Louvain School of Management - Louvain Finance

Victor DeMiguel

London Business School

Frédéric D. Vrins

Louvain Finance Center (LFIN), UC Louvain; Center for Operations Research and Econometrics (CORE), UC Louvain

Date Written: January 28, 2020

Abstract

A popular approach to enhance portfolio diversification is to use the factor-risk-parity portfolio, which is the portfolio whose return variance is spread equally among the principal components (PCs) of asset returns. Although PCs are unique and useful for dimension reduction, they are an arbitrary choice because any rotation of the PCs remains uncorrelated. This is problematic because we demonstrate that any portfolio is the factor-variance-parity portfolio corresponding to a specific rotation of the PCs. To overcome this problem, we rely on the factor-risk-parity portfolio based on the independent components (ICs), which are the rotation of the PCs that are maximally independent, and thus, account for higher moments in asset returns. We demonstrate that using the IC-variance-parity portfolio helps to reduce the return kurtosis. We also show how to exploit the near independence of the ICs to parsimoniously estimate the factor-risk-parity portfolio based on Value-at-Risk. Finally, we empirically demonstrate that portfolios based on ICs outperform those based on PCs, and the minimum-variance portfolio.

Keywords: Portfolio selection, risk parity, factor analysis, principal component analysis, higher moments

JEL Classification: G11

Suggested Citation

Lassance, Nathan and DeMiguel, Victor and Vrins, Frederic Daniel, Optimal Portfolio Diversification via Independent Component Analysis (January 28, 2020). Available at SSRN: https://ssrn.com/abstract=3285156 or http://dx.doi.org/10.2139/ssrn.3285156

Nathan Lassance (Contact Author)

UCLouvain - UCLouvain, Louvain School of Management - Louvain Finance ( email )

voie du roman, 34
Louvain-la-neuve, 1348
Belgium

Victor DeMiguel

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Frederic Daniel Vrins

Louvain Finance Center (LFIN), UC Louvain ( email )

Voie du Roman Pays 34
Louvain-la-Neuve, 1348
Belgium

HOME PAGE: http://www.uclouvain.be/frederic.vrins

Center for Operations Research and Econometrics (CORE), UC Louvain ( email )

Voie du Roman Pays 34
Louvain-la-Neuve,, B-1348
Belgium

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