Target Matrix Estimators in Risk-Based Portfolios

Abstract

Portfolio weights solely based on risk avoid estimation error from the sample mean, but they are still affected from the misspecification in the sample covariance matrix. To solve this problem, we shrink the covariance matrix towards the Identity, the Variance Identity, the Single-index model, the Common Covariance, the Constant Correlation and the Exponential Weighted Moving Average target matrices. By an extensive Monte Carlo simulation, we offer a comparative study of these target estimators, testing their ability in reproducing the true portfolio weights. We control for the dataset dimensionality and the shrinkage intensity in the Minimum Variance, Inverse Volatility, Equal-risk-contribution and Maximum Diversification portfolios. We find out that the Identity and Variance Identity have very good statistical properties, being well-conditioned also in high-dimensional dataset. In addition, the these two models are the best target towards to shrink: they minimise the misspecification in risk-based portfolio weights, generating estimates very close to the population values. Overall, shrinking the sample covariance matrix helps reducing weights misspecification, especially in the Minimum Variance and the Maximum Diversification portfolios. The Inverse Volatility and the Equal-Risk-Contribution portfolios are less sensitive to covariance misspecification, hence they benefit less from shrinkage.