Portfolio Optimization Using a Block Structure for the Covariance Matrix

David Disatnik, Saggi Katz

Research output: Contribution to journalArticlepeer-review

Abstract

Implementing in practice the classical mean-variance theory for portfolio selection often results in obtaining portfolios with large short sale positions. Also, recent papers show that, due to estimation errors, existing and rather advanced mean-variance theory-based portfolio strategies do not consistently outperform the naïve 1/N portfolio that invests equally across N risky assets. In this paper, we introduce a portfolio strategy that generates a portfolio, with no short sale positions, that can outperform the 1/N portfolio. The strategy is investing in a global minimum variance portfolio (GMVP) that is constructed using an easy to calculate block structure for the covariance matrix of asset returns. Using this new block structure, the weights of the stocks in the GMVP can be found analytically, and as long as simple and directly computable conditions are met, these weights are positive.

Original languageEnglish
Pages (from-to)806-843
Number of pages38
JournalJournal of Business Finance and Accounting
Volume39
Issue number5-6
DOIs
StatePublished - Jun 2012

Keywords

  • Block covariance matrix
  • Portfolio optimization
  • Short sale constraints
  • The 1/N portfolio

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