SSRN Id2161564 PDF

Construction, management, and performance of
sparse Markowitz portfolios

Julie Henriques1 and Juan-Pablo Ortega2
Abstract
We study different implementations of the sparse portfolio construction and rebalancing method
introduced by Brodie et al [BDDM+ 09]. This technique is based on the use of a l1 -norm (sum of the
absolute values) type penalization on the portfolio weights vector that regularizes the Markowitz
portfolio selection problem by automatically eliminating the dynamical redundancies present in
the time evolution of asset prices. We make specific recommendations as to the different estimation
techniques for the parameters needed in the use of the method and we prove its good performance in
realistic situations involving different rebalancing frequencies and transaction costs. Our empirical
findings show that the beneficial effects of the use of sparsity constraints are robust with respect to
the choice of trend and covariance estimation methods used in its implementation.
Keywords: Markowitz portfolios, penalized regression, portfolio selection, portfolio management, spar-
sity, Sharpe ratio.
1 Introduction
Modern portfolio theory is based on the idea that rational asset selection has to take into account not
only the expected returns but also the risk involved in the investment. In Markowitz’s foundational
work [Mar52] it is the variability in the returns of the assets that is taken as a proxy for that risk; as
a corollary of this assumption it is shown that diversification in portfolio construction has beneficial
effects as it allows taking advantage of the correlation existing between the different assets available.
The two major limitations of diversification as a performance enhancement technique are its time
dependence and the presence of dynamic redundancies in the markets. The first point has to do with
the fact that the correlation between assets is not static and evolves in time. It is a well known empirical
fact that in moments of high market volatility, asset returns tend to be highly correlated; this effect is
highly damaging and spoils the expected benefits of well diversified strategies when it is most needed.
This phenomenon is known in the time series literature as multivariate conditional heteroscedasticity
and its presence in stock returns is well documented (see [BLR06] and references therein).
Concerning the existence of dynamic redundancies in the markets, it is a fact that the dynamic
diversity of market returns is not given by the number of different assets available in it; for example,
assets in a given activity sector or geographical region tend to behave similarly. This feature causes the
appearance of zero eigenvalues in the covariance matrices between the considered assets that renders
the standard Markowitz method highly unstable and impossible to use in many situations.
A quick way to illustrate the phenomena that we just described consists of carrying out a quick
principal component analysis of the S&P 100 and S&P 500 indices. In Figure 1, we have first performed
1 Tea-Cegos Deployment. 11 rue Denis Papin. F-25000 Besançon. jhenriques@deployment.org
3 Corresponding author. Centre National de la Recherche Scientifique, Laboratoire de Mathématiques de Besançon,
Université de Franche-Comté, UFR des Sciences et Techniques. 16, route de Gray. F-25030 Besançon cedex. France.
Juan-Pablo.Ortega@univ-fcomte.fr
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Construction, management, and performance of sparse Markowitz portfolios 2
an elementary EWMA (Exponentially Weighted Moving Average) estimation of the daily conditional
covariance matrices {Ht } of the components of the S&P 100 and S&P 500 indices in the three years
between January 2007 and January 2010. More specifically, if {rt } denotes the logreturns vectors, we
assume that the covariance matrices {Ht } are recursively determined by the relation
Ht = (1 − λ)rt−1 rTt−1 + λHt−1 ,
where we have used the value λ = 0.94 suggested by the RiskMetrics manual for the use of EWMA in
the presence of daily quotes [Ris96]. Once we have the matrices {Ht } at hand, we compute every day the
minimum number of their eigenvalues (or their corresponding principal components) needed to account
for 90% of the trace. Roughly speaking, this exercise provides an indication of the number of underlying
components needed each day to explain 90% of the observed volatility. These numbers are depicted in
the top two graphs of Figure 1 and show that the dynamic complexity of the market is limited and has
more to do with the general volatility conditions than with the number of assets considered. Indeed,
in moments of low volatility we see that the number of principal components needed to explain most
of the dynamical complexity is between 15 and 20 for the S&P 100 and between 20 and 30 for the
S&P 500; during the volatility shocks in the Fall of 2008 we see that these numbers drop to 7 and 9
respectively. This simple analysis shows the massive redundancies present in the markets and hence the
Figure 1: Number of principal components of the EWMA conditional correlations. λ = 0.94.
little interest of constructing diversification strategies based on a large number of assets, especially in the
moments of high volatility in which the dynamic complexity of the logreturns shrinks dramatically. The
attentiveness to limiting this number is of particular interest when one takes into account the transaction
costs associated to the necessary periodic portfolio rebalancing, that are of particular significance for
small and medium size investors.
From a more analytical point of view, this study also points out how the trace of the covariance
matrices is clumped in a limited number of significant eigenvalues, while the rest (several hundred in the
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case of the S&P 500 index) are all going to be very small, even though never zero due to non-arbitrage
considerations. Given that the construction of standard Markowitz portfolios requires the inversion of
these matrices, those pervasive small eigenvalues explain the well known instability associated to this
procedure.
A solution to the problems that we just described, proposed in [BDDM+ 09], consists of using a l1 -
penalty term on the portfolio weights at the time of setting up the traditional Markowitz optimization
problem. This technique has been introduced in a more standard regression setup under the name of
LASSO [Tib96] and it is known to promote sparsity (see [CDS01] and references therein) which, under
certain hypotheses, makes of it a powerful variable selection tool.
In this paper we study in detail this approach and we complete the work carried out in [BDDM+ 09]
by evaluating the joint performance of this technique when put together with different forecasting tools
for the estimation of expected volatilities and returns needed at the time of setting up the portfolio
optimization problem. In the paper [BDDM+ 09], that we use as an starting point for our work, only a
historical estimation method is considered; we complete that approach with a slightly different historical
procedure that takes into consideration the envisioned forecasting horizon, as well as with different
model based multistep forecasting methods for covariance matrices and trends. Our empirical findings
show that the use of sparsity constraints in the construction and the rebalancing of portfolios has always
beneficial effects regardless the trend and covariance estimation methods used, which points to desirable
robustness properties of this procedure.
Additionally, we have explored in detail the convenience of using sparsity constraints in various
portfolio rebalancing strategies, specially in the presence of transaction costs, situation in which there
is an evident interest in limiting the turnover associated to portfolio adjustment. The empirical proof
of the pertinence of the sparse approach to portfolio management is one of the main contributions of
this paper.
The paper is organized in three sections that contain a reminder of the sparse portfolio selection and
rebalancing technique (Section 2), a description of the covariance and trend forecasting methods with
which we experiment (Section 3), and a last section that describes our empirical findings.
Notation and conventions: All along the paper, bold symbols like r denote column vectors, r0
denotes the transposed vector. Given a filtered probability space (Ω, P, F, {Ft }t∈N ) and X, Y two
random variables, we will denote by Et [X] := E[X|Ft ] the conditional expectation, covt (X, Y ) :=
cov(X, Y |Ft ) := Et [XY ] − Et [X]Et [Y ] the conditional covariance, and by vart (X) := Et [X 2 ] − Et [X]2
the conditional variance. A discrete-time stochastic process {Xt }t∈N is predictable when Xt is Ft−1 -
measurable, for any t ∈ N.
Acknowledgments: We thank Stéphane Chrétien and Christine De Mol for various insights about this
project that have significantly improved it. We acknowledge partial support from Tea-Cegos Deployment
S.L. and the Centro para el Desarrollo Tecnológico Industrial (CDTI, project number IDI-20100893) of
the Spanish Ministerio de Ciencia e Innovación.
2 The sparse portfolio selection and rebalancing problems

All along this paper we will consider a market with N risky securities whose synchronized prices at
time t will be denoted by St := (St1 , . . . , StN )0 . Additionally, we will write rti := log(Sti /St−1
i
) and
nrti := (Sti − St−1
i i
)/St−1 to denote the one-period log-return and net return, respectively, associated
0 0
to the ith asset at time t. The symbols rt := rt1 , . . . , rtN and nrt := nrt1 , . . . , nrtN denote the
corresponding vectors. Given a positive integer h, we will denote by rt [h] = log(St /St−h ) and nrt [h] :=
(St − St−h )/St−h the multiperiod returns. We recall that rt [h] = rt + · · · + rt−h+1 , that is, the multistep
log-returns are obtained by flow time aggregation of the single step log-returns time series. The net
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returns are a first order Taylor approximation of the log-returns, indeed
rt = log (1 + nrt ) = nrt + o(nrt2 ), (2.1)
which allows us to identify them whenever we are in the presence of small returns. 0
Portfolios are defined by providing a portfolio vector φt := φ1t , . . . , φNt that determines the
number of holdings φit of the ith security at time t. The value of the portfolio Vtφ at a given time t
is given by the scalar product Vtφ = hφt , St i. The weight wti at time t of the ith asset is given by the
percentage value
φit Sti
wti := .
hφt , St i
PN i
By construction i=1 wt = 1. Net returns and weights are particularly convenient when handling
portfolio returns; indeed, if a portfolio is held during h time periods, that is φt = φt−1 = · · · = φt−h ,
then the corresponding h-period portfolio net return nrtφ [h] is given by
Vtφ − Vt−h
φ
nrtφ [h] := φ
= hwt−h , nrt [h]i.
Vt−h
The sparse portfolio selection problem. Given a point in time T , an investment horizon h and a
target return ρ, the standard Markowitz portfolio selection problem consists of determining the weight
vector wT such that h i
ρ = ET nrTφ +h [h] = wT0 · ET [nrT +h [h]] (2.2)
and that at the same time the conditional variance experienced by the investment

varT nrTφ +h [h] = wT0 ET [nrT +h [h] · nrT +h [h]0 ] wT − wT0 ET [nrT +h [h]] · ET [nrT +h [h]0 ] wT , (2.3)
is minimized. In this expressions, for any random variable X, the symbol ET [X] denotes the condi-
tional expectation E[X | FT ] with respect to the sigma algebra FT that encodes all the information
accumulated by the investor up to time T . If in order to make the notation simpler we write
µ := ET [nrT +h [h]] and C := ET [nrT +h [h] · nrT +h [h]0 ] − ET [nrT +h [h]] · ET [nrT +h [h]0 ] (2.4)
then the Markowitz portfolio selection can be rewritten as the optimization problem
wT = arg min (w0 Cw) such that w0 µ = ρ, w0 1N = 1, (2.5)

w∈RN
with 1N the vector containing N ones. The redundancies present in the market that we described in
the introduction produce colinearity effects among different asset returns which, in turn, force in real
situations some of the eigenvalues of C to be significantly different from zero and the rest very small; as
a consequence, the condition number of C (ratio between the largest and the smallest eigenvalue) may
become very large which makes the optimization problem (2.5) very unstable.
The solution proposed in [BDDM+ 09] consists of regularizing (2.5) by adding a penalty proportional
to the l1 -norm of w, that is:
wT = arg min (w0 Cw + λkwk1 ) such that w0 µ = ρ, w0 1N = 1, (2.6)

w∈RN
PN
where kwk1 := i=1 |wi | and λ ∈ R is a parameter that adjusts the importance of the regularization
penalty. We encourage the reader to check [BDDM+ 09] for a good comprehensive description of the
effects of this penalization in the optimization problem. In our work we will mainly focus on its sparsify-
ing effect, that is, by tuning the importance of the penalty using the parameter λ, the investor can limit
the amount of open positions (that is, wi 6= 0) in its portfolio; this approach has a regularizing effect
on (2.5) because, roughly speaking, the first assets that are going to be eliminated from the portfolio as
the parameter λ goes up are those that exhibit colinearity with the rest of the portfolio and hence force
the appearance of small eigenvalues in the matrix C.
The sparse portfolio rebalancing problem. The l1 penalization strategy that we just used for
portfolio selection can also be exploited in the adjustment of large portfolios with the goal of limiting
the turnover and hence the trading costs. In that situation, the penalty term is applied not to the
portfolio weights but to the rebalancing term that we seek to compute as a solution of an appropriately
formulated optimization problem. More explicitly, consider a preexisting portfolio with weights vector
w and that we want to rebalance into a new one w + ∆w using the correction term ∆w in such a way
that Markowitz type targets are met and that the number of assets that are touched by the procedure
is kept under control. One way to do that is by solving the l1 -penalized optimization problem:
0
such that ∆w0 µ = 0, ∆w0 1N = 0. (2.7)

∆wT = arg min (w + ∆w) C (w + ∆w) + λk∆wk1
∆w∈RN
3 Trend and covariance forecasting

The formulation of any of the optimization problems that we just spelled out requires estimates of the
forecasts µ and C in (2.4). Much of the good performance of the resulting optimized portfolios depends
on the quality of these predictions. In this work we will carry out a comparison between the results
obtained with different forecasting strategies that we now describe.
3.1 Historical forecasting methods

This is the simplest method and consists of using as forecasts the empirical estimators of the mean
and the covariance applied to the historical net returns of the assets that compose the portfolio. The
only eventual difficulty that deserves some explanation appears when the forecasting horizon does not
coincide with the sampling frequency of the asset returns; in that situation there are two approaches
that can be taken:
(i) Applying the empirical estimators to the time series of net returns annualized according
to the forecasting horizon: let {nr1 , . . . , nrT } be the historical net-returns of one of the assets
and {r1 , . . . , rT } the corresponding log-returns. If the forecasting horizon is h-time steps, let
{h · r1 , . . . , h · rT } be the h-annualized log-returns and let {nr1h := (h · nr1 + 1)h − 1, . . . , nrTh :=
(h · nrT + 1)h − 1} be the corresponding h-annualized net returns. With this approach we define:
T T
1X h 1 X
µ= nr and C := (nrhi − µ) · (nrhi − µ)0 .
T i=1 i T − 1 i=1
(ii) Applying the empirical estimators to time aggregated series of net returns according to
the forecasting horizon: let {S0 , . . . , ST } be the historical prices of one of the assets. Using the
notation introduced in Section 2 we construct a time series {nrh [h], . . . , nrT [h]} of multiperiod net-
returns nri [h] := (Si − Si−h ) /Si−h and we then take as h-forecasts for the trend and covariance
the value of the corresponding empirical estimators obtained out of these time aggregated returns.
The method explained in the first point is the only one used in [BDDM+ 09]; for our work we have opted
for the second one since its construction is free of assumptions on the underlying price process.
3.2 Model based forecasting methods

Instead of using directly the historical returns as in the previous paragraph, this approach takes ad-
vantage of that information in order to estimate a multivariate model that captures simultaneously the
dynamics of the different assets. All the models that we will be using refer to the log-returns {rt } and
have the form
1/2
rt = c + Ht t with c ∈ RN and t ∼ IIDN (0, IN ) . (3.1)
The family {Ht } is made of positive semidefinite and predictable matrices, that is, for each t ∈
{1, . . . , T }, the matrix Ht is a Ft−1 -measurable random variable, with Ft = σ(1 , . . . , t ) the sigma
algebra generated by the innovations {t } up to time t. With this model prescription, the multistep
trend and variance forecasting is straightforward if by (2.1) we identify net returns with log-returns.
(i) Trend forecasting:
h i h i
1/2 1/2
µ := ET [rT +h [h]] = ET [rT +1 + · · · + rT +h ] = hc + ET HT +1 T +1 + . . . + ET HT +h T +h
h i h h ii h h ii
1/2 1/2 1/2
= hc + ET HT +1 T +1 + ET ET +1 HT +2 T +2 + . . . + ET ET +h−1 HT +h T +h .
We now note that for any i ∈ {1, . . . , T } the predictability hypothesis implies that:
h i
1/2 1/2
ET +i−1 HT +i T +i = HT +i ET +i−1 [T +i ] = 0,
and hence
µ = hc. (3.2)
(ii) Covariance forecasting:

h
X
C := ET [rT +h [h] · rT +h [h]0 ] − ET [rT +h [h]] · ET [rT +h [h]0 ] = ET rT +i · r0T +j − h2 cc0

i,j=1
h
0 h 0
1/2 1/2 1/2 1/2
X X
= ET c+ HT +i T +i c + HT +i T +i +2 ET c+ HT +i T +i c + HT +j T +j − h2 cc0
i=1 i<j=1
 
h h i h h h ii
1/2 1/2 1/2 1/2
X X
= hcc0 + ET HT +i T +i 0T +i HT +i + 2  cc0 + ET ET +j HT +i T +i 0T +j HT +j  − h2 cc0
i=1 i<j=1
h
X
= ET [HT +i ] .
i=1
In conclusion,
h
X
C= ET [HT +i ] . (3.3)
i=1
Remark 3.1 It is worth emphasizing that trend estimation and forecasting of financial returns is in
practice an extremely challenging task. On one hand, the extreme efficiency of markets creates time
uncorrelation among the returns, which justifies the absence of autoregressive terms in the generic
model (3.1). More importantly, one empirically observes a highly unfavorable signal-noise ratio in
financial returns time series, that is, volatilities are several orders of magnitude superior to average
returns, which makes the estimation of the trend vector c in (3.1) extremely difficult.
We now compute (3.3) under the different model specifications that we will be using in our empirical
research.
Exponentially Weighted Moving Average (EWMA) prescription. This is the covariance dy-
namics proposed by Riskmetrics [Ris96] and it amounts to a vector analog of the non-stationary IGARCH
scheme. More specifically, for any t:
0 1/2 1/2
Ht = λHt−1 + (1 − λ) (rt−1 − c) (rt−1 − c) = λHt−1 + (1 − λ)Ht−1 t−1 0t−1 Ht−1 , (3.4)
with λ a real coefficient that is tuned according to the sampling frequency. In the case of monthly
data Riskmetrics proposes λ = 0.97 and λ = 0.94 for daily data. An important feature of the EWMA
prescription is that it makes the covariance matrices martingales with respect to the shifted filtration
generated by the innovations. Indeed, for any t:
1/2 1/2
Et [Ht+1 ] = Ht+1 and Et [Ht+2 ] = λHt+1 + (1 − λ)Ht+1 Et t+1 0t+1 Ht+1 = Ht+1 .

In general, this implies that for any i ≥ 1:
Et [Ht+i ] = Ht+1
and hence
h
X
C= ET [HT +i ] = hHT +1 . (3.5)
i=1
GARCH based conditional correlation models. We will be using two prescriptions, namely
the Constant (CCC) and the Dynamic (DCC) Conditional Correlation models, introduced in [Bol90]
and [Eng02], respectively. These are parsimonious multivariate heteroscedastic models based on the
combination of separate descriptions for the univariate variances using GARCH [Bol86] with very un-
complicated dynamic rules for the behavior of the correlation of the residuals (constant for CCC and
autoregressive for DCC).
Given that both multivariate models are based on the univariate GARCH prescription, we start with
a brief description of this model as well as the volatility and trend multistep forecasting formulas that
go with it. In this work we will limit ourselves to the simplest GARCH(1,1) case that models single
log-returns {rt } according to the the recurrence relation
rt = c + σt t with t ∼ IIDN(0, 1) and σt2 = α0 + α1 (rt−1 − c)2 + βσt−1

2
. (3.6)
The coefficients α0 , α1 , and β are real numbers subjected to the constraints α0 > 0, α1 , β ≥ 0, and
α1 +β < 1, that ensure the existence of a unique stationary solution and the positivity of the conditional
variance process {σt } that is by construction predictable.
The relations (3.6) can be used to construct forecasting formulas for the volatilities of the log-returns
and their flow aggregation. Indeed, a straightforward inductive argument shows that for any t and h ≥ 2:
h−1
2
2 2 [ 2
2 1 − (α1 + β) h−1 2
σd
t+1 = Et σt+1 = σt+1 and σ t+h = Et σt+h = α0 + (α1 + β) σt+1 . (3.7)
1 − (α1 + β)
Consequently, using this relation and (3.3):
h h−1
X 2 2 (h − 1)α0 2 α0 X
VarT (rT +h [h]) = ET σT +i = σT +1 + + σT +1 − (α1 + β)i
i=1
1 − (α 1 + β) 1 − (α 1 + β) i=1
h

hα0 α 0 1 − (α1 + β)
= + σT2 +1 − . (3.8)
1 − (α1 + β) 1 − (α1 + β) 1 − (α1 + β)
Analogously, according to (3.2), the best forecast for the trend of the log-returns is
µ = ET [rT +h [h]] = hc. (3.9)
Another approach to constructing a predictor for the multistep net returns consists of using the pre-
scription (3.6) to directly forecast the asset prices, which immediately yields a plug-in forecast for the
net returns. In our empirical study we will see that this scheme produces better results than (3.9). More
specifically, (3.6) can be rewritten as
St = St−1 exp (r + σt t ) ,
with St denoting the asset price at time t. The one and two step mean square error minimizing forecasts
for the price St are given by
2
σt+1
St+1 = Et [St+1 ] = St exp r +
b , (3.10)
2
σ2

exp 2r + 12 α0 + β1 σt+1
2
− α1 σ2t+1−2
t+1
Sbt+2 = Et [St+2 ] = St q . (3.11)
2
1 − α1 σt+1
Even though it is not possible to proceed analytically to obtain forecasts like (3.10) and (3.11) beyond
two time steps, we can consider the pseudo information set Fbt+2 generated by S1 , . . . , St , Sbt+1 , Sbt+2 and
to use (3.10) and (3.11) to obtain predictions Sbt+3 , Sbt+4 . This mechanism can be used recursively to
produce forecasts of the prices at arbitrary horizons which in turn yield plug-in predictors n crT [h] for
the multistep net returns of the form
SbT +h − ST
n
crT [h] = . (3.12)
ST
Constant Conditional Correlation (CCC). The starting point of this model consists of fitting a
one dimensional GARCH model like in (3.6) to the historical log-returns time series {r1i , . . . , rTi } of each
of the N individual assets. This procedure yields N different descriptions:
rti = ci + σti it with t ∈ {1, . . . , T } and ∈ {1, . . . , N }. (3.13)
The time series of filtered residuals {i1 , . . . , iT } of each different asset are in general correlated; let R
be the corresponding correlation matrix, that is:
T T
1X i j 1 X (rti − ci ) (rtj − cj )
Rij := t t = . (3.14)
T t=1 T t=1 σti σtj
The CCC prescription stipulates that the log-returns follow a model of the form (3.1), where the com-
ponents of the trend parameter c are those obtained out of the one dimensional models (3.13), and the
conditional covariance matrices {Ht } are constructed out of the one-dimensional conditional variances
and the correlation matrix R in (3.14) that is assumed to remain constant, via the relation:
(Ht )ij = Rij σti σtj , for any i, j ∈ {1, . . . , N } and t ∈ {1, . . . , T }
This can be rewritten in matrix form as
Dt = diag σt1 , . . . , σtN ,

Ht = Dt RDt , where t ∈ {1, . . . , T }.
Covariance forecasting with the CCC prescription is relatively straightforward but requires the use of
approximations. In our work we will consider two different ones:
(i) Covariance forecasting using multistep individual volatility forecasting. The first goal
is constructing a forecast H [ i
T +h for HT +h . We start by constructing forecasts σT +h for the one-
\
i
dimensional volatilities σT +h using the plug-in predictor obtained as the square root of (3.7). We
thereby obtain a matrix forecast D \ T +h out of which we construct HT +h as
\
H
\T +h = DT +h RDT +h .
\ \ (3.15)
Finally, by (3.3), the predicted covariance matrix C of the flow aggregated log-returns is given by
h
X
C= H
\ T +i . (3.16)
i=1
(ii) Covariance forecasting using the volatility forecast of the flow time-aggregated log-
returns. We start by using (3.8) in order to construct plug-in forecasts σ\ i
T +h [h] for the volatility

of the multistep log-returns rTi +h [h]. Let D\ 1 N
T +h [h] = diag σT +h [h], . . . , σT +h [h] and take R[h] :=
hR as the approximate annualized constant correlation matrix with respect to the forecasting
period. Following this scheme, the forecast for the covariance matrix C of the flow aggregated
log-returns is given by
C = D\ \
T +h [h]R[h]DT +h [h].
Dynamic Conditional Correlation (DCC). This model is a generalization of CCC in which the
correlation structure R is allowed to evolve in time according to the prescription that we now describe.
As in (3.13) we start with one dimensional GARCH estimations for the log-returns time series of the
individual assets. Then define
Qt = (1 − α − β) Q + αt−1 0t−1 + βQt−1 ,
where Q is the unconditional covariance matrix of the standardized residuals {1 , . . . , T } coming from
the first stage estimation (3.13). We then define
− 21 − 12
Rt = (diag Qt ) Qt (diag Qt ) , (3.17)
where diag Qt is the diagonal matrix constructed with the diagonal elements of Qt . The conditional
covariance matrices {Ht } are obtained as
Ht = Dt Rt Dt . (3.18)
Major advantages of this prescription are the built-in parsimony when compared to other multivariate
volatility models (like VEC, BEKK, etc), the possibility of estimation using a two stages approach that
takes care separately of (3.13) and of the parameters α and β in (3.17), and finally the automatic positive
definiteness of the conditional covariance matrices (3.18). More specifically, it can be proved [ES01] that
the usual stationarity constraints imposed at the time of the first stage one-dimensional estimation (3.13)
suffice to ensure that the matrices {Ht } obtained in (3.18) are actual covariance matrices.
Multistep covariance forecasting using this model also requires the use of approximations. Two
natural options have been considered in the literature [ES01], namely:
(i) For any integer i we assume that ET t+i 0t+i ≈ ET [Qt+i ]: it is easy to see that with this approx-

imation, the h-step ahead forecast Q\ T +h of QT +h is given by
h−2
X
D
\T +h := ET [QT +h ] = (1 − α − β)Q(α + β)i + (α + β)h−1 QT +1 ,
i=0
which can be used to construct corresponding forecasts R\T +h and HT +h for the correlation and
\
the covariance matrices RT +h and HT +h , respectively:
− 12 − 12
R
\T +h = diag Q
\T +h Q
\T +h diag Q
\T +h , H
\T +h = DT +h RT +h DT +h ,
\\\ (3.19)
where the forecast D

\T +h is constructed as in (3.15).
(ii) We assume that covariance and correlation matrices are very close, that is, Q ≈ R and that
ET [Rt+i ] ≈ ET [Qt+i ] for any integer i: with this approximation we can directly obtain forecasts
R\T +h for the correlation matrices RT +h using
h−2
X
R
\ T +h := ET [RT +h ] = (1 − α − β)R(α + β)i + (α + β)h−1 RT +1 , (3.20)
i=0
which, in turn, produces a forecast H

\T +h for the conditional covariance HT +h using the second
relation in (3.19).
Finally, using any of the two approximations, the predicted covariance matrix C of the flow aggregated
log-returns is given by (3.3) as
Xh
C= H
\ T +i . (3.21)
i=1
4 Empirical study
This section has two main objectives: first, we show the good out-of-sample performance of appropriately
sparsified portfolios using the techniques described in Section 2 and we compare at the same time the
results obtained by the different trend and covariance forecasting techniques described in Section 3.
Second, we will see how the use of sparsity constraints in portfolio rebalancing strategies produces
extremely beneficial effects in turnover reduction maintaining, at the same time, competitive out-of-
sample performances.
As in [BDDM+ 09], we use for this empirical study one of the assets universe compiled by Fama and
French that is readily available from Kenneth R. French’s webpage. More specifically, we will be using a
set that contains monthly data for 48 industry sector portfolios (abbreviated as FF48 in what follows).
In this work we will be considering the values that span the period going from January 1976 through
December 2010.
Sparse portfolio construction and management requires solving the optimization problems (2.6)
and (2.7). The l1 -penalization that they include is obviously non-differentiable, which has motivated
the introduction of different regularization and adapted optimization schemes; see for example [Nes05]
and references therein. In [BDDM+ 09] it is used the homotopy method, also known as Least Angle
Regression (LARS) [OPT00b, OPT00a, EHJT04]; in our empirical study we will use the CVX libraries
developed by Michael Grant and Stephen Boyd [GB11, GB08] using a disciplined convex programming
approach.
4.1 Performance of regularized sparse portfolios

The exercise that we carry out in the following paragraphs follows the pattern established in [BDDM+ 09]
and aims at showing the performance of regularized sparse portfolios constructed using the different
forecasting techniques for the returns covariances and trends presented in the previous section. The
different performances that will be obtained will be compared against the following two benchmarks: the
naı̈ve equal weighting strategy and the Markowitz scheme. Regarding the naı̈ve equal weighting
strategy, recent studies [DGU09] show how within the Markowitz framework it is difficult to find portfolio
design algorithms that consistently outperform the simple strategy that consists of allocating an equal
weight to each asset in the portfolio. As to the Markowitz scheme, the correlation level present in the
FF48 returns and its cardinality still allows for the solution of the classical Markowitz optimization
problem.
Specifications of the experiment. Each month between January 1981 through December 2010 we
construct a collection of portfolios by solving the optimization problems
wT = arg min (w0 Cw + λkwk1 ) such that w0 µ ≥ ρ, w0 1N = 1. (4.1)

w∈RN
Notice that this coincides with (2.6) with the equality w0 µ = ρ replaced by an inequality. The portfolios
are constructed according to three different forecasting horizons in mind: one month, six months, and
twelve months. These horizons are taken into account at the time of constructing the forecasts for the
parameters µ and C needed in (4.1). All along the paper, the minimum performance parameter ρ is
chosen dynamically each month as the average net return exhibited by the naı̈ve equally distributed
portfolios constructed every month in the preceding five years and kept for the three different invest-
ment horizons; in other words ρ is the historical average net-return of the equally distributed portfolios
constructed according to the second prescription in Section 3.1. The covariance forecasting techniques
that we compare in the construction of these monthly portfolios are: historical estimation according
to the second prescription in Section 3.1, exponentially weighted moving average (EWMA), using the
expression (3.3), constant conditional correlation (CCC) using the approximation that leads to the mul-
tistep forecasts (3.15) and (3.16), and dynamic conditional correlation (DCC) using the approximation
that leads to the multistep forecasts (3.20) and (3.21).
Regarding trend forecasting, we have used the historical estimation according to the second point
in Section 3.1 and the univariate plug-in price-based GARCH forecasting in (3.10)–(3.12). Other tech-
niques, like returns-based GARCH forecasting as in (3.9) have been left out since they did not provide
results of the same quality.
We emphasize that the forecasting horizon used in the construction of µ and C using the different
methods that we just listed is in agreement with the planned duration of the investment that will
be also used for an ex-post evaluation of its performance. This way to proceed differs from the one
used in [BDDM+ 09] where the portfolios are designed to be kept for one year but their performance is
evaluated monthly.
For each different investment horizon and each forecasting technique we then tune up the constant
λ in (4.1) that modulates the strength of the sparsity constraint so that portfolios with a prescribed
number of active assets, that is they have a non-zero weight, are obtained.
Notice that since we are constructing new portfolios every month according to different methodolo-
gies, what we are measuring with this exercise is not the performance obtained by a single investor but
the one achieved by a group of investors that would use the same portfolio design strategy at different
points in time.
To sum up, each month in the period between January 1981 and December 2010, we construct
a collection of portfolios parametrized by the forecasting techniques used in the estimation of µ and
C, the investment horizon, and the number of active assets allowed and controlled using the sparsity
penalization. Each of these portfolios are held during the time span that was prescribed at the time
of their construction and their actual performance is recorded. This provides us, for each kind of
portfolio, with a time series containing 360 portfolio returns whose mean m and standard deviation
σ is used to construct a Sharpe ratio m/σ that measures the trade-off, for that particular portfolio
specification, between returns (profits and losses) and volatility (risk taken); this gives hence a rational
measure of the investment performance associated to the portfolio construction method. The results
with the resulting Sharpe ratios associated to each method are represented in Figures 2, 3, and 4,
classified by the investment horizon of one, six, or twelve months, respectively, considered at the time of
both the portfolio design and ex-post performance evaluation. Each of these three figures contain two
horizontal lines that represent the performance of the two benchmarks listed above, namely, the equal
weighting strategy and the standard Markowitz scheme; regarding the latter we have represented the
implementation of the method that uses the covariance and trend forecasting methods that provide the
best possible results for each horizon; details are provided in the figure captions.
A quick inspection of the results represented in these figures allows us to draw several important
conclusions:
(i) The sparse regularization of the Markowitz portfolio construction scheme allows for the achievement
of portfolio performances that are significantly and consistently superior to those proposed by the
naı̈ve equal weighting strategy. Despite the methodological differences in the historical forecasting
method and in the shift between design and performance evaluation, this statement is consistent
with the results in [BDDM+ 09].
(ii) Given a specific forecasting method, there are always sparsified portfolios (that contain strictly
less than 48 active assets) for all investment horizons that outperform the traditional Markowitz
portfolio with all the assets active. This fact shows that the pertinence of the use of sparsity
constraints in portfolio construction is robust with respect to the choice of trend and covariance
estimation method.
(iii) For the sampling frequency (monthly) of the returns that we are using and the forecasting horizons
considered (1, 6, and 12 months) the interest of heteroscedastic modeling is apparent concerning
trend forecasting but more limited when it comes to the prediction of covariance matrices; regard-
ing the latter, more elementary historical methods seem to suffice and it is only for the one month
forecasting horizon that DCC outperforms the historical approach. This lack of significant perfor-
mance can be due to the approximations used at the time of multistep forecasting and also to the
fact that heteroscedasticity decreases with flow time-aggregation [DN93]. Similar situations have
been described in other empirical financial applications (see for example [LW01] and references
therein).
4.2 Sparse portfolio management

The simulations in this section complete the work carried out in the previous one and show the pertinence
of the use of sparsity penalizations not only at the stage of the portfolio construction but also in its
management. We will see how imposing reasonable sparsity constraints in the portfolio rebalancing has
a limited impact in the performance when the investor is not subjected to transaction costs and how
these slight differences quickly amplify, become substantial, and make advisable the sparse approach as
soon as we start considering them. This empirical finding is one of the main contributions of this paper.
More in detail, we consider in the simulations a fixed amount that is invested on January 1981 in the
FF48 assets universe according to both the standard Markowitz scheme and to the sparse strategy (2.6)
for which the penalty strength parameter λ is tuned so that the number of active assets of the portfolio
coincides with the following prescribed quantities: 8, 17, 25, 33, and 41. These portfolios are kept
for twelve months and are then rebalanced every year according to the following three prescriptions:
a new standard Markowitz portfolio is constructed, a new sparsified portfolio is chosen with the same
number of active assets, and a new portfolio is obtained using the sparse readjustment technique in (2.7)
subjected to the constraint ∆w0 · µ ≥ 0. The penalty strength constant λ is tuned so that a prespecified
number of adjusted assets is obtained.
For each rebalancing we compute the associated money turnover, that is, the total cash amount
0
involved in the transformation of the portfolio. More specifically, if φt := φ1t , . . . , φN
t denotes the
portfolio vector at time t, then the cash turnover Ot involved in the rebalancing at time t consisting in
modifying the portfolio φt−1 into φt is given by
N
X i
φt − φit−1 · St .

Ot =
i=1
In our study we will consider transaction costs that are computed as a fixed percentage of this turnover;
this is equivalent to taking into consideration identical trading fees for selling and buying assets whose
total is a fixed percentage F of the traded amount. Using these quantities and notations we define the
effective net return enrtφ of a portfolio as a return that takes into account the money spent in the
rebalancing: more specifically, if the portfolio φ was obtained after a rebalancing at time t − 1 incurring
in transaction fees F · Ot−1 paid as a percentage F of the total turnover Ot−1 , then the effective net
return obtained at time t is
V φ − V φ − F · Ot−1
enrt = t φ t−1 .
Vt−1 + F · Ot−1
This definition provides us in our study with a time series of annual effective net returns that we will
use to compute a net Sharpe ratio associated to each portfolio adjustment strategy as a function
of the transaction fees percentage F . We note that in this exercise we have only considered at the
time of portfolio construction the historical method for the covariance forecasting (not mentioned in the
legends); regarding the trend forecasting, we have examined the historical (“historical returns” in the
legends) and the univariate plug-in price-based GARCH forecasting methods (“GARCH returns” in the
legends) in (3.10)–(3.12).
The results of these experiments are collected in Figures 5–9 where the effective portfolio perfor-
mances, measured using the net Sharpe ratio, are depicted for each adjustment strategy as a function
of the level F of transaction fees paid during the periodic rebalancings. A number of conclusions can
be readily drawn:
(i) Even though the sparse regularization technique is obtained as a constraint on the standard Markowitz
scheme, the performances obtained are always better in the presence of this penalization, even in
the absence of transaction fees and for different strengths of this penalization (or equivalently, for
different active asset cardinalities). This confirms the results presented in Figures 2–4 obtained
using a different construction scheme and shows the pertinence of this regularization scheme as
far as performance is concerned.
(ii) The pertinence of the use of sparsity constraints in the portfolio management context is robust
with respect to the choice of trend and covariance estimation method and always brings beneficial
effects in terms of final net portfolio performance and turnover limitation.
(iii) In the presence of transaction fees, the beneficial effects of sparsity both in the portfolio con-
struction or in the adjustment are dramatic. Using sparsity constraints only on the design of the
portfolios (“Sparse portfolio” in the legends of Figures 5–9) increases the effective performance
and makes it less sensitive than a pure Markowitz scheme to the presence of transaction fees; the
use of sparse adjustment constraints lowers the performance with respect to the “sparse portfolio”
case but it makes it in exchange practically insensitive to transaction fees in such a way that
beyond a certain fees level threshold it becomes the most advantageous rebalancing technique.
(iv) The more assets are allowed to be regularly rebalanced, the closer the performance of the sparse
adjustment technique gets to the “sparse portfolio” technique. This number should be chosen as
a function of the transaction fees level to which the investor is exposed.
(v) The beneficial effects of turnover limitation using sparse rebalancing techniques are particularly
visible in moments of high volatility. In order to visualize this fact, we have depicted in Figures 10–
12 the total turnover at each annual rebalancing according to the different portfolio construction
and adjustment techniques considered. These figures show how, for example, the high market
volatility during the burst of the dot-com bubble or the Great Recession in 2008-2009 would
have made explode the turnover in the portfolio rebalancing had we followed a pure Markowitz
approach; in turn it is also shown how any sparse approach to this task keeps the adjustment
exchanges relatively stable.
5 Conclusions
In this paper we have studied different implementations of the sparse portfolio construction and re-
balancing method introduced by Brodie et al [BDDM+ 09] by considering various covariance and trend
forecasting techniques. We have empirically tested the performance of the proposed schemes on a bench-
mark data set containing monthly quotes of 48 industry sector portfolios (abbreviated FF48) constructed
by Fama and French. Our findings can be summarized as follows:
• The sparse regularization of the Markowitz portfolio construction scheme allows for the achieve-
ment of portfolio performances that are significantly and consistently superior to those proposed
by the naı̈ve equal weighting strategy. Moreover, given a specific forecasting method for covari-
ances and trends, there are always sparsified portfolios for all the investment horizons considered
(1, 6, and 12 months) that outperform the traditional Markowitz portfolio. This fact shows that
the pertinence of the use of sparsity constraints in portfolio construction is robust with respect to
the choice of trend and covariance estimation method.
• For the sampling frequency (monthly) of the returns that we are using and the forecasting horizons
considered, the interest of heteroscedastic modeling is apparent concerning trend forecasting but
more limited when it comes to the prediction of covariance matrices. It is only for the one month
forecasting horizon that a model based method outperforms the historical approach. This lack of
significant performance can be due to the approximations used at the time of multistep forecasting
and also to the fact that heteroscedasticity decreases with flow time-aggregation.
• In the presence of transaction fees, the beneficial effects of sparsity are spectacular both in the
portfolio construction and in the adjustment. Using sparsity constraints only on the design of the
portfolios increases the effective performance and makes it less sensitive to transaction fees than
a pure Markowitz scheme; the use of sparse adjustment constraints lowers the performance but it
makes it in exchange practically insensitive to transaction fees so that beyond a certain fees level
threshold it becomes the most advantageous rebalancing technique. Consequently, the number of
assets that are allowed to be regularly rebalanced should be chosen as a function of the transaction
fees level to which the investor is exposed.
• The beneficial effects of turnover limitation using sparse rebalancing techniques are particularly
visible in moments of high volatility.
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Figure 2: Sharpe ratios associated to the portfolios constructed with an investment horizon of one month using different
covariance and trend forecasting methods. In the legend, the word before the slash provides the covariance
forecasting method, and the one after it refers to the trend. For this particular investment horizon, the Markowitz
scheme has been implemented using the historical estimation method for the covariance matrix and price-based
GARCH forecasting for the trend.
Figure 3: Sharpe ratios associated to the portfolios constructed with an investment horizon of six months using different
scheme has been implemented using DCC for the covariance matrix and price-based GARCH forecasting for the
trend.
Figure 4: Sharpe ratios associated to the portfolios constructed with an investment horizon of twelve months using different
scheme has been implemented using the historical estimation method for both the covariance matrix and the
trend.
Figure 5: Comparison of effective portfolio performances obtained by different portfolio adjustment techniques as a func-
tion of the transaction fees level. “Markowitz” refers to portfolios constructed and annually adjusted using the
standard Markowitz scheme. “Sparse portfolio” refers to portfolios constructed and adjusted under a sparsity
constraint that limits the number of active assets to eight. “Sparse adjustment” refers to a portfolio constructed
under a sparsity constraint that limits the number of active assets to eight and that is subsequently adjusted
using a penalty that limits the number of adjusted assets to the figure indicated between parenthesis. Covariance
forecasting is always carried out historically; trend forecasting is done either historically (“historical returns” in
the legends) or with a univariate GARCH (“GARCH returns” in the legend).
constraint that limits the number of active assets to seventeen. “Sparse adjustment” refers to a portfolio con-
structed under a sparsity constraint that limits the number of active assets to seventeen and that is subsequently
adjusted using a penalty that limits the number of adjusted assets to the figure indicated between parenthesis.
Covariance forecasting is always carried out historically; trend forecasting is done either historically (“historical
returns” in the legends) or with a univariate GARCH (“GARCH returns” in the legend).
constraint that limits the number of active assets to twenty five. “Sparse adjustment” refers to a portfolio
constructed under a sparsity constraint that limits the number of active assets to twenty five and that is sub-
sequently adjusted using a penalty that limits the number of adjusted assets to the figure indicated between
parenthesis. Covariance forecasting is always carried out historically; trend forecasting is done either historically
(“historical returns” in the legends) or with a univariate GARCH (“GARCH returns” in the legend).
constraint that limits the number of active assets to thirty three. “Sparse adjustment” refers to a portfolio
constructed under a sparsity constraint that limits the number of active assets to thirty three and that is sub-
sequently adjusted using a penalty that limits the number of adjusted assets to the figure indicated between
parenthesis. Covariance forecasting is always carried out historically; trend forecasting is done either historically
(“historical returns” in the legends) or with a univariate GARCH (“GARCH returns” in the legend).
constraint that limits the number of active assets to forty one. “Sparse adjustment” refers to a portfolio con-
structed under a sparsity constraint that limits the number of active assets to forty one and that is subsequently
adjusted using a penalty that limits the number of adjusted assets to the figure indicated between parenthesis.
Covariance forecasting is always carried out historically; trend forecasting is done either historically (“historical
returns” in the legends) or with a univariate GARCH (“GARCH returns” in the legend).
Figure 10: Total turnover at each annual rebalancing according to the different portfolio construction and adjustment
techniques indicated in the legend. The year one point corresponds to the first rebalancing in January 1982.

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Construction, management, and performance of

sparse Markowitz portfolios

Ht = (1 − λ)rt−1 rTt−1 + λHt−1 ,

Figure 1: Number of principal components of the EWMA conditional correlations. λ = 0.94.

2 The sparse portfolio selection and rebalancing problems

returns are a first order Taylor approximation of the log-returns, indeed

rt = log (1 + nrt ) = nrt + o(nrt2 ), (2.1)

wT = arg min (w0 Cw) such that w0 µ = ρ, w0 1N = 1, (2.5)

wT = arg min (w0 Cw + λkwk1 ) such that w0 µ = ρ, w0 1N = 1, (2.6)

3 Trend and covariance forecasting

3.1 Historical forecasting methods

3.2 Model based forecasting methods

(ii) Covariance forecasting:

In general, this implies that for any i ≥ 1:

rt = c + σt t with t ∼ IIDN(0, 1) and σt2 = α0 + α1 (rt−1 − c)2 + βσt−1

imation, the h-step ahead forecast Q\ T +h of QT +h is given by

where the forecast D

which, in turn, produces a forecast H

4.1 Performance of regularized sparse portfolios

wT = arg min (w0 Cw + λkwk1 ) such that w0 µ ≥ ρ, w0 1N = 1. (4.1)

4.2 Sparse portfolio management

[Mar52] H. Markowitz. Portfolio selection. J. Finance, 7:77–91, 1952.

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Construction, management, and performance of

sparse Markowitz portfolios

Ht = (1 − λ)rt−1 rTt−1 + λHt−1 ,

Figure 1: Number of principal components of the EWMA conditional correlations. λ = 0.94.

2 The sparse portfolio selection and rebalancing problems

returns are a first order Taylor approximation of the log-returns, indeed

rt = log (1 + nrt ) = nrt + o(nrt2 ), (2.1)

wT = arg min (w0 Cw) such that w0 µ = ρ, w0 1N = 1, (2.5)

wT = arg min (w0 Cw + λkwk1 ) such that w0 µ = ρ, w0 1N = 1, (2.6)

3 Trend and covariance forecasting

3.1 Historical forecasting methods

3.2 Model based forecasting methods

(ii) Covariance forecasting:

In general, this implies that for any i ≥ 1:

rt = c + σt t with t ∼ IIDN(0, 1) and σt2 = α0 + α1 (rt−1 − c)2 + βσt−1

imation, the h-step ahead forecast Q\ T +h of QT +h is given by

where the forecast D

which, in turn, produces a forecast H

4.1 Performance of regularized sparse portfolios

wT = arg min (w0 Cw + λkwk1 ) such that w0 µ ≥ ρ, w0 1N = 1. (4.1)

4.2 Sparse portfolio management

[Mar52] H. Markowitz. Portfolio selection. J. Finance, 7:77–91, 1952.

Potrebbero piacerti anche

rt = c + σt t with t ∼ IIDN(0, 1) and σt2 = α0 + α1 (rt−1 − c)2 + βσt−1