Conditional Portfolios with Feature Flattening
Conditional Portfolios
When I first started working at a quant fund I tried to read about portfolio theory. (Beyond, you know, "Hedge Funds for Dummies.") I learned about various objectives and portfolio constraints, including the Markowitz portfolio, which felt very natural. Markowitz solves the mean-variance optimization problem, as well as the Sharpe maximization problem, namely
This is solved, up to scaling, by the Markowitz portfolio \(\Sigma^{-1}\mu\).
When I first read about the theory behind Markowitz, I did not read anything about where \(\mu\) and \(\Sigma\) come from. I assumed the authors I was reading were talking about the vanilla sample estimates of the mean and covariance, though the theory does not require this.
There are some problems with the Markowitz portfolio. For us, as a small quant fund, the most pressing issue was that holding the Markowitz portfolio based on the historical mean and covariance was not a good look. You don't get paid "2 and twenty" for computing some long term averages.
Rather than holding an unconditional portfolio, we sought to construct a conditional one, conditional on some "features". (I now believe this topic falls under the rubric of "Tactical Asset Allocation".) We stumbled on two simple methods for adapting Markowitz theory to accept conditioning information: Conditional Markowitz, and "Flattening".
Conditional Markowitz
Suppose you observe some \(l\) vector of features, \(f_i\) prior to the time you have to allocate into \(p\) assets to enjoy returns \(x_i\). Assume that the returns are linear in the features, but the covariance is a long term average. That is
Note that Markowitz theory never really said how to estimate mean …
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