Feature selection for portfolio optimization

Most portfolio selection rules based on the sample mean and covariance matrix perform poorly out-of-sample. Moreover, there is a growing body of evidence that such optimization rules are not able to beat simple rules of thumb, such as 1/N. Parameter uncertainty has been identified as one major reaso...

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Bibliographic Details
Published in:Annals of operations research 2017-09, Vol.256 (1), p.21-40
Main Authors: Bjerring, Thomas Trier, Ross, Omri, Weissensteiner, Alex
Format: Article
Language:English
Subjects:
Analysis
Astronomical models
Business and Management
Combinatorics
Covariance matrix
Economic models
Management science
Methods
Operations research
Operations Research/Decision Theory
Optimization
Optimization theory
Parameter estimation
Portfolio management
S.i.: Apmod 2014
Theory of Computation
Universe
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Summary:Most portfolio selection rules based on the sample mean and covariance matrix perform poorly out-of-sample. Moreover, there is a growing body of evidence that such optimization rules are not able to beat simple rules of thumb, such as 1/N. Parameter uncertainty has been identified as one major reason for these findings. A strand of literature addresses this problem by improving the parameter estimation and/or by relying on more robust portfolio selection methods. Independent of the chosen portfolio selection rule, we propose using feature selection first in order to reduce the asset menu. While most of the diversification benefits are preserved, the parameter estimation problem is alleviated. We conduct out-of-sample back-tests to show that in most cases different well-established portfolio selection rules applied on the reduced asset universe are able to improve alpha relative to different prominent factor models.
ISSN:0254-5330
1572-9338
DOI:10.1007/s10479-016-2155-y