Model-based vs. agnostic methods for the prediction of time-varying covariance matrices

Abstract

This article is written in memory of Harry Markowitz, the founder of modern portfolio theory. We report a few human perspectives of his character, we review a large number of his contributions, published both in operations research and finance oriented journals, and we focus on one of the most critical, and still open, portfolio theory issues, the forecast of covariance matrices. Our contribution in this paper is placed exactly towards this direction. More specifically, we compare the performances of several approaches to predict the variance-covariance matrices of vectors of asset returns, through simulated and real data experiments: some dynamic models such as Dynamic Conditional Correlation (DCC) and C-vine GARCH on one side, and several agnostic methods (Average Oracle, usual “Sample” matrix) on the other side. The most robust methods seem to be DCC and the Average Oracle approaches.