Universal Portfolio Shrinkage
Working Paper 32004
DOI 10.3386/w32004
Issue Date
We introduce a novel shrinkage methodology for building optimal portfolios in environments of high complexity, where the number of assets is comparable to or larger than the number of observations. Our universal portfolio shrinkage approximator (UPSA) is given in closed form, is easy to implement, and improves upon existing shrinkage methods. It exhibits an explicit two-fund separation, complementing the Markowitz portfolio with an optimal complexity correction. UPSA does not annihilate the low-variance principal components (PCs) of returns; instead, it optimally reweighs them and produces a stochastic discount factor that substantially improves on its feasible PC-sparse counterparts.