Optimal Asset Allocation with Factor Models for Large Portfolios

Mohammad Pesaran and Paolo Zaffaroni

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: This paper characterizes the asymptotic behaviour, as the number of assets gets arbitrarily large, of the portfolio weights for the class of tangency portfolios belonging to the Markowitz paradigm. It is as- sumed that the joint distribution of asset returns is characterized by a general factor model, with possibly heteroskedastic components. Under these conditions, we establish that a set of appealing properties, so far unnoticed, characterize traditional Markowitz portfolio trading strategies. First, we show that the tangency portfolios fully diversify the risk associated with the factor component of asset return innovations. Second, with respect to determination of the portfolio weights, the conditional distribution of the factors is of second-order importance as compared to the distribution of the factor loadings and that of the idiosyncratic components. Third, although of crucial importance in forecasting asset returns, current and lagged factors do not enter the limit portfolio returns. Our theoretical results also shed light on a number of issues discussed in the literature regarding the limiting properties of portfolio weights such as the diversi¯ability property and the number of dominant factors.

Keywords: Asset allocation; Large Porftolios; Factor models; Diversi¯cation. (search for similar items in EconPapers)
JEL-codes: C32 C52 C53 G1 (search for similar items in EconPapers)
Pages: 24
Date: 2008-03
New Economics Papers: this item is included in nep-ecm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

Downloads: (external link)
http://www.econ.cam.ac.uk/research-files/repec/cam/pdf/cwpe0813.pdf Working Paper Version (application/pdf)

Related works:
Working Paper: Optimal Asset Allocation with Factor Models for Large Portfolios (2008)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cam:camdae:0813

Access Statistics for this paper

More papers in Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge
Bibliographic data for series maintained by Jake Dyer ().