Briner, Beat G. and Connor, Gregory
How much structure is best?
A comparison of market model, factor model
and unstructured equity covariance matrices.
Journal of Risk, 10 (4).
This paper compares three approaches to estimating equity covariance
matrices: a factor model, a market model and an unstructured asset-by-asset
model. These approaches make different trade-offs between estimation
variance and model specification error. We explore this trade-off with
a simulation experiment and with an empirical analysis of UK equity
portfolios. The factor model is found to perform best for large investment
universes and typical sample lengths. The market model underperforms due
to excessive specification error while an asset-by-asset model with a short
half-life of 22 days underperforms due to high estimation variance. The
importance of properly accounting for serial correlation is highlighted.
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