A combinatorial optimization approach to scenario filtering in portfolio selection

Abstract

Recent studies stressed the fact that covariance matrices computed from empirical financial time series appear to contain a high amount of noise. This makes the classical Markowitz Mean–Variance Optimization model unable to correctly evaluate the performance associated to selected portfolios. Since the Markowitz model is still one of the most used practitioner-oriented tool, several filtering methods have been proposed in the literature to overcome the problem. Among them, the two most promising ones refer to the Random Matrix Theory and to the Power Mapping strategy. The basic idea of these methods is to transform the estimated correlation matrix before applying the Mean–Variance Optimization model. However, experimental analysis shows that these two strategies are not always effective when applied to real financial datasets.

In this paper we propose a new filtering method based on Quadratic Programming. We develop a Mixed Integer Quadratic Programming model, which is able to filter those observations that may affect the performance of the selected portfolio. We discuss the properties of this new model and test it on some real financial datasets. We compare the out-of-sample performance of our portfolios with the one of the portfolios provided by the two above mentioned alternative filtering methods giving evidence that our method outperforms them. Although our model can be solved efficiently with standard optimization solvers, the computational burden increases for large datasets. To solve also these problems, we propose a heuristic procedure, which, on the basis of our empirical results, shows to be both efficient and effective.