Economic benefits of using realized covariance forecasts in risk-based portfolios

ABSTRACT

This article examines the economic benefit of using the realized covariance matrix forecasts, for constructing the risk-based portfolios. We use the two-scale realized covariance estimator (TSC), the jump robust two-scale realized covariance estimator (RTSC) and the realized bipower covariance estimator (BPC), to forecast the daily realized covariance matrix. Using these covariance matrix forecasts, we implement three risk-based portfolios: the global minimum variance portfolio, the equal risk contribution portfolio and the most diversified portfolio. There is evidence that the portfolio performance improves by using TSC or RTSC estimators as compared to the daily-returns-based estimator. The performance gains are robust to the choice of risk-based portfolio strategy, the degree of investor’s relative risk-aversion, the market conditions and the choice of time intervals.

KEYWORDS:

• Realized covariance
• bipower variation
• risk-based portfolios
• microstructure noise
• risk parity

JEL CLASSIFICATION:

• G1
• G11

Notes

¹ Risk-based products are offered by several asset management companies, namely, Invesco, AQR Capital Management, Putnam Investments, Global X Funds, Direxion, PanAgora Asset Management, Salient, Bridgewater Associates, Innealta Capital, Amundi Funds.

² Some examples include the Fairfax County Employees’ Retirement System, the San Joaquin County Employees’ Retirement Association, the Employee pension fund of United Technologies, the Fresno County (California) Employees’ Retirement Association, the Ontario Municipal Employees Retirement System, and the Rabobank Pensioenfonds.

³ Fleming, Kirby, and Ostdiek (2003) create portfolios using three future contracts: the S&P 500 futures (Chicago Mercantile Exchange), Treasury bond futures (Chicago Board of Trade), and gold futures (New York Mercantile Exchange).