Portfolio selection with parsimonious higher comoments estimation

29 Pages Posted: 1 Oct 2019 Last revised: 7 Apr 2021

See all articles by Nathan Lassance

Nathan Lassance

UCLouvain - UCLouvain, Louvain School of Management - Louvain Finance

Frédéric D. Vrins

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

Date Written: March 16, 2021

Abstract

Large investment universes are usually fatal to portfolio strategies optimizing higher moments because of computational and estimation issues resulting from the number of parameters involved. In this paper, we introduce a parsimonious method to estimate higher moments that consists of projecting asset returns onto a small set of maximally independent factors found via independent component analysis (ICA). In contrast to principal component analysis (PCA), we show that ICA resolves the curse of dimensionality affecting the comoment tensors of asset returns. The method is easy to implement, computationally efficient, and makes portfolio strategies optimizing higher moments appealing in large investment universes. Considering the value-at-risk as a risk measure, an investment universe of up to 500 stocks and adjusting for transaction costs, we show that our ICA approach leads to superior out-of-sample risk-adjusted performance compared with PCA, equally weighted, and minimum-variance portfolios.

Keywords: Portfolio selection; Estimation risk; Independent component analysis; Principal component analysis; Higher moments

JEL Classification: C1; G11

Suggested Citation

Lassance, Nathan and Vrins, Frederic Daniel, Portfolio selection with parsimonious higher comoments estimation (March 16, 2021). Journal of Banking and Finance (2021), 126(9), 106-115., Available at SSRN: https://ssrn.com/abstract=3455400 or http://dx.doi.org/10.2139/ssrn.3455400

Nathan Lassance (Contact Author)

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

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

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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