Performance Analysis and Optimal Selection of Large Minimum Variance Portfolios Under Estimation Risk

Abstract

We study the realized variance of sample minimum variance portfolios of arbitrarily high dimension. We consider the use of covariance matrix estimators based on shrinkage and weighted sampling. For such improved portfolio implementations, the otherwise intractable problem of characterizing the realized variance is tackled here by analyzing the asymptotic convergence of the risk measure. Rather than relying on less insightful classical asymptotics, we manage to deliver results in a practically more meaningful limiting regime, where the number of assets remains comparable in magnitude to the sample size. Under this framework, we provide accurate estimates of the portfolio realized risk in terms of the model parameters and the underlying investment scenario, i.e., the unknown asset return covariance structure. In-sample approximations in terms of only the available data observations are known to considerably underestimate the realized portfolio risk. If not corrected, these deviations might lead in practice to inaccurate and overly optimistic investment decisions. Therefore, along with the asymptotic analysis, we also provide a generalized consistent estimator of the out-of-sample portfolio variance that only depends on the set of observed returns. Based on this estimator, the model free parameters, i.e., the sample weighting coefficients and the shrinkage intensity defining the minimum variance portfolio implementation, can be optimized so as to minimize the realized variance while taken into account the effect of estimation risk. Our results are based on recent contributions in the field of random matrix theory. Numerical simulations based on both synthetic and real market data validate our theoretical findings under a non-asymptotic, finite-dimensional setting. Finally, our proposed portfolio estimator is shown to consistently outperform a widely applied benchmark implementation