A Dynamic Semiparametric Characteristics-based Model for Optimal Portfolio Selection

32 Pages Posted: 12 Mar 2021 Last revised: 5 May 2021

See all articles by Gregory Connor

Gregory Connor

National University of Ireland, Maynooth (NUI Maynooth) - Department of Economics

Shaoran Li

University of Cambridge - Faculty of Economics

Oliver B. Linton

University of Cambridge

Date Written: February 10, 2021

Abstract

This paper develops a two-step semiparametric methodology for portfolio weight selection for characteristics- based factor-tilt and factor-timing investment strategies. We build upon the expected utility maximization framework of Brandt (1999) and Aït-sahalia and Brandt (2001). We assume that asset returns obey a characteristics- based factor model with time-varying factor risk premia as in Li and Linton (2020). We prove under our return- generating assumptions that in a market with a large number of assets, an approximately optimal portfolio can be established using a two-step procedure. The first step finds optimal factor-mimicking sub-portfolios using a quadratic objective function over linear combinations of characteristics-based factor loadings. The second step dynamically combines these factor-mimicking sub-portfolios based on a time-varying signal, using the investor’s expected utility as the objective function. We develop and implement a two-stage semiparametric estimator. We apply it to CRSP (Center for Research in Security Prices) and FRED (Federal Reserve Economic Data) data and find excellent in-sample and out-sample performance consistent with investors’ risk aversion levels.

Keywords: Portfolio management; Single index; GMM;

JEL Classification: C14; G11.

Suggested Citation

Connor, Gregory and Li, Shaoran and Linton, Oliver B., A Dynamic Semiparametric Characteristics-based Model for Optimal Portfolio Selection (February 10, 2021). Michael J. Brennan Irish Finance Working Paper Series Research Paper No. 21-1, Available at SSRN: https://ssrn.com/abstract=3803193 or http://dx.doi.org/10.2139/ssrn.3803193

Gregory Connor (Contact Author)

National University of Ireland, Maynooth (NUI Maynooth) - Department of Economics ( email )

County Kildare
Ireland

Shaoran Li

University of Cambridge - Faculty of Economics ( email )

Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom

Oliver B. Linton

University of Cambridge ( email )

Faculty of Economics
Cambridge, CB3 9DD
United Kingdom

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
70
Abstract Views
264
rank
389,968
PlumX Metrics