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Sharpe Ratio in High Dimensions: Cases of Maximum Out of Sample, Constrained Maximum, and Optimal Portfolio Choice

by   Mehmet Caner, et al.

In this paper, we analyze maximum Sharpe ratio when the number of assets in a portfolio is larger than its time span. One obstacle in this large dimensional setup is the singularity of the sample covariance matrix of the excess asset returns. To solve this issue, we benefit from a technique called nodewise regression, which was developed by Meinshausen and Buhlmann (2006). It provides a sparse/weakly sparse and consistent estimate of the precision matrix, using the Lasso method. We analyze three issues. One of the key results in our paper is that mean-variance efficiency for the portfolios in large dimensions is established. Then tied to that result, we also show that the maximum out-of-sample Sharpe ratio can be consistently estimated in this large portfolio of assets. Furthermore, we provide convergence rates and see that the number of assets slow down the convergence up to a logarithmic factor. Then, we provide consistency of maximum Sharpe Ratio when the portfolio weights add up to one, and also provide a new formula and an estimate for constrained maximum Sharpe ratio. Finally, we provide consistent estimates of the Sharpe ratios of global minimum variance portfolio and Markowitz's (1952) mean variance portfolio. In terms of assumptions, we allow for time series data. Simulation and out-of-sample forecasting exercise shows that our new method performs well compared to factor and shrinkage based techniques.


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