Multi-period portfolio selection with drawdown control

In this article, model predictive control is used to dynamically optimize an investment portfolio and control drawdowns. The control is based on multi-period forecasts of the mean and covariance of financial returns from a multivariate hidden Markov model with time-varying parameters. There are comp...

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Bibliographic Details
Published inAnnals of operations research Vol. 282; no. 1-2; pp. 245 - 271
Main Authors Nystrup, Peter, Boyd, Stephen, Lindström, Erik, Madsen, Henrik
Format Journal Article
LanguageEnglish
Published New York Springer US 01.11.2019
Springer
Springer Nature B.V
Subjects
Business and Management
Combinatorics
Covariance
Dynamic asset allocation
Forecasting
Hidden Markov models
Investment
Markov chains
Matematik
Mathematics
Maximum drawdown
Methods
Model predictive control
Natural Sciences
Naturvetenskap
Operations research
Operations Research/Decision Theory
Optimal control
Optimization
Portfolio management
Predictive control
Probability Theory and Statistics
Regime switching
Risk management
S.I.: Application of O. R. to Financial Markets
Sannolikhetsteori och statistik
Theory of Computation
Denmark
Model predictive control
Risk management
Forecasting
Dynamic asset allocation
Regime switching
Maximum drawdown
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Summary:In this article, model predictive control is used to dynamically optimize an investment portfolio and control drawdowns. The control is based on multi-period forecasts of the mean and covariance of financial returns from a multivariate hidden Markov model with time-varying parameters. There are computational advantages to using model predictive control when estimates of future returns are updated every time new observations become available, because the optimal control actions are reconsidered anyway. Transaction and holding costs are discussed as a means to address estimation error and regularize the optimization problem. The proposed approach to multi-period portfolio selection is tested out of sample over two decades based on available market indices chosen to mimic the major liquid asset classes typically considered by institutional investors. By adjusting the risk aversion based on realized drawdown, it successfully controls drawdowns with little or no sacrifice of mean–variance efficiency. Using leverage it is possible to further increase the return without increasing the maximum drawdown.
ISSN:0254-5330
1572-9338
DOI:10.1007/s10479-018-2947-3