Disentangling the role of variance and covariance information in portfolio selection problems Articles uri icon



publication date

  • June 2018

start page

  • 57

end page

  • 76


  • 1


  • 19

International Standard Serial Number (ISSN)

  • 1469-7688

Electronic International Standard Serial Number (EISSN)

  • 1469-7696


  • The covariation among financial asset returns is often a key ingredient used in the construction of optimal portfolios. Estimating covariances from data, however, is challenging due to the potential influence of estimation error, specially in high-dimensional problems, which can impact negatively the performance of the resulting portfolios. We address this question by putting forward a simple approach to disentangle the role of variance and covariance information in the case of mean-variance efficient portfolios. Specifically, mean-variance portfolios can be represented as a two-fund rule: one fund is a fully invested portfolio that depends on diagonal covariance elements, whereas the other is a long-short, self financed portfolio associated with the presence of non-zero off-diagonal covariance elements. We characterize the contribution of each of these two components to the overall performance in terms of out-of-sample returns, risk, risk-adjusted returns and turnover. Finally, we provide an empirical illustration of the proposed portfolio decomposition using both simulated and real market data.


  • inverse covariance matrix; minimum variance portfolio; reward-to-risk timing; tangency portfolio; volatility timing