Optimal Portfolio Using Factor Graphical Lasso*.

Lee, Tae-Hwy; Seregina, Ekaterina

Graphical models are a powerful tool to estimate a high-dimensional inverse covariance (precision) matrix, which has been applied for a portfolio allocation problem. The assumption made by these models is a sparsity of the precision matrix. However, when stock returns are driven by common factors, such assumption does not hold. We address this limitation and develop a framework, Factor Graphical Lasso (FGL), which integrates graphical models with the factor structure in the context of portfolio allocation by decomposing a precision matrix into low-rank and sparse components. Our theoretical results and simulations show that FGL consistently estimates the portfolio weights and risk exposure and also that FGL is robust to heavy-tailed distributions which makes our method suitable for financial applications. FGL-based portfolios are shown to exhibit superior performance over several prominent competitors including equal-weighted and index portfolios in the empirical application for the S&P500 constituents.

SPARSE matrices; LOW-rank matrices; RATE of return on stocks; FACTOR structure; RISK exposure

Journal of Financial Econometrics, 2024, Vol 22, Issue 3, p670

1479-8409

Academic Journal

10.1093/jjfinec/nbad011