Optimal Portfolio Choice with Unknown Benchmark Efficiency

74 Pages Posted: 23 Feb 2021 Last revised: 23 May 2023

See all articles by Raymond Kan

Raymond Kan

University of Toronto - Rotman School of Management

Xiaolu Wang

Iowa State University

Date Written: May 21, 2023

Abstract

When a benchmark model is inefficient, including test assets in addition to the benchmark portfolios can improve the performance of the optimal portfolio. In reality, the efficiency of a benchmark model relative to the test assets is ex ante unknown; moreover, the optimal portfolio is constructed based on estimated parameters. Therefore, whether and how to include the test assets becomes a critical question faced by real world investors. For such a setting, we propose a combining portfolio strategy, optimally balancing the value of including test assets and the effect of estimation errors.

The proposed combining strategy can work together with some existing estimation risk reduction strategies. In both empirical datasets and simulations, we show that our proposed combining strategy performs well.

Keywords: portfolio choice; model efficiency; estimation risk; optimal combining

JEL Classification: G11, G12, C11

Suggested Citation

Kan, Raymond and Wang, Xiaolu, Optimal Portfolio Choice with Unknown Benchmark Efficiency (May 21, 2023). Rotman School of Management Working Paper No. 3760640, Available at SSRN: https://ssrn.com/abstract=3760640 or http://dx.doi.org/10.2139/ssrn.3760640

Raymond Kan

University of Toronto - Rotman School of Management ( email )

105 St. George Street
Toronto, Ontario M5S3E6
Canada
416-978-4291 (Phone)
416-971-3048 (Fax)

Xiaolu Wang (Contact Author)

Iowa State University ( email )

2167 Union Drive
Ames, IA 50011
United States

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