Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds
Portfolio construction is an important practical problem in finance. In the traditional approach, introduced by Markowitz, one assumes normally distributed returns and constructs a portfolio with a minimum risk (measured by the standard deviation of portfolio returns) for a specified (and minimally...
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| Format: | Article |
| Language: | English |
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Elsevier
2022-12-01
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| Series: | Machine Learning with Applications |
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| Online Access: | http://www.sciencedirect.com/science/article/pii/S2666827022001098 |
| _version_ | 1811178209414217728 |
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| author | Andrei Vasiukevich Eugene Pinsky |
| author_facet | Andrei Vasiukevich Eugene Pinsky |
| author_sort | Andrei Vasiukevich |
| collection | DOAJ |
| description | Portfolio construction is an important practical problem in finance. In the traditional approach, introduced by Markowitz, one assumes normally distributed returns and constructs a portfolio with a minimum risk (measured by the standard deviation of portfolio returns) for a specified (and minimally acceptable) return.In practice, returns are not normally distributed and have heavy tails. As a result, the normality assumption severely underestimates risk. It has been long suggested that a more appropriate way is to model returns by using alpha-stable distributions.In this paper, we use elliptical stable distributions for optimal stable portfolio construction. We illustrate this by considering portfolios from S&P 500 sector exchange-traded funds (ETFs).Our main results indicate that stable portfolios are in general comparable with standard Markowitz portfolios. But we discovered a few properties of stable distributions that are promising for optimal portfolio selection problem. Stable risk estimation for next year is much closer to the actual portfolio risk, stable portfolios are more balanced, so they better handle maximum restriction on component weights, and stable portfolios are more resilient to extreme market conditions.Both stable and normal optimal portfolios outperform S&P 500 index and equally-weighted ETF portfolio in most years.We propose an investment strategy that uses both stable and normal distributions for building optimal portfolios. The return of this strategy exceeds the return of the strategies which use only stable or only normal distributions. |
| first_indexed | 2024-04-11T06:15:45Z |
| format | Article |
| id | doaj.art-db324c2e6dc14900a622e97d6b5c2280 |
| institution | Directory Open Access Journal |
| issn | 2666-8270 |
| language | English |
| last_indexed | 2024-04-11T06:15:45Z |
| publishDate | 2022-12-01 |
| publisher | Elsevier |
| record_format | Article |
| series | Machine Learning with Applications |
| spelling | doaj.art-db324c2e6dc14900a622e97d6b5c22802022-12-22T04:41:05ZengElsevierMachine Learning with Applications2666-82702022-12-0110100434Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded fundsAndrei Vasiukevich0Eugene Pinsky1Yandex School of Data Analysis, Yandex, 11k2 Timura Frunze st., Moscow, 119021, Russian Federation; Department of Innovation and High Technology, Moscow Institute of Physics and Technology, 1 “A” Kerchenskaya st., Moscow, 117303, Russian Federation; Corresponding author at: Department of Innovation and High Technology, Moscow Institute of Physics and Technology, 1 “A” Kerchenskaya st., Moscow, 117303, Russian Federation.Department of Computer Science, Metropolitan College, Boston University, 1010 Commonwealth Avenue, Boston, 02215, MA, USAPortfolio construction is an important practical problem in finance. In the traditional approach, introduced by Markowitz, one assumes normally distributed returns and constructs a portfolio with a minimum risk (measured by the standard deviation of portfolio returns) for a specified (and minimally acceptable) return.In practice, returns are not normally distributed and have heavy tails. As a result, the normality assumption severely underestimates risk. It has been long suggested that a more appropriate way is to model returns by using alpha-stable distributions.In this paper, we use elliptical stable distributions for optimal stable portfolio construction. We illustrate this by considering portfolios from S&P 500 sector exchange-traded funds (ETFs).Our main results indicate that stable portfolios are in general comparable with standard Markowitz portfolios. But we discovered a few properties of stable distributions that are promising for optimal portfolio selection problem. Stable risk estimation for next year is much closer to the actual portfolio risk, stable portfolios are more balanced, so they better handle maximum restriction on component weights, and stable portfolios are more resilient to extreme market conditions.Both stable and normal optimal portfolios outperform S&P 500 index and equally-weighted ETF portfolio in most years.We propose an investment strategy that uses both stable and normal distributions for building optimal portfolios. The return of this strategy exceeds the return of the strategies which use only stable or only normal distributions.http://www.sciencedirect.com/science/article/pii/S2666827022001098Stable distributionsMarkowitz portfolio theoryExchange-traded fundsα-stable portfoliosEfficient frontier |
| spellingShingle | Andrei Vasiukevich Eugene Pinsky Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds Machine Learning with Applications Stable distributions Markowitz portfolio theory Exchange-traded funds α-stable portfolios Efficient frontier |
| title | Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds |
| title_full | Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds |
| title_fullStr | Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds |
| title_full_unstemmed | Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds |
| title_short | Constructing portfolios using stable distributions: The case of S&P 500 sectors exchange-traded funds |
| title_sort | constructing portfolios using stable distributions the case of s p 500 sectors exchange traded funds |
| topic | Stable distributions Markowitz portfolio theory Exchange-traded funds α-stable portfolios Efficient frontier |
| url | http://www.sciencedirect.com/science/article/pii/S2666827022001098 |
| work_keys_str_mv | AT andreivasiukevich constructingportfoliosusingstabledistributionsthecaseofsp500sectorsexchangetradedfunds AT eugenepinsky constructingportfoliosusingstabledistributionsthecaseofsp500sectorsexchangetradedfunds |