N ov 2 00 7 On estimating covariances between many assets with histories of highly variable length

Quantitative portfolio allocation requires the accurate and tractable estimation of covariances between a large number of assets, whose histories can greatly vary in length. Such data are said to follow a monotone missingness pattern, under which the likelihood has a convenient factorization. Upon further assuming that asset returns are multivariate normally distributed, with histories at least as long as the total asset count, maximum likelihood (ML) estimates are easily obtained by performing repeated ordinary least squares (OLS) regressions, one for each asset. Things get more interesting when there are more assets than historical returns. OLS becomes unstable due to rank–deficient design matrices, which is called a “big p small n” problem. We explore remedies that involve making a change of basis, as in principal components or partial least squares regression, or by applying shrinkage methods like ridge regression or the lasso. This enables the estimation of covariances between large sets of assets with histories of essentially arbitrary length, and offers improvements in accuracy and interpretation. Our methods are demonstrated on randomly generated data, and on real financial time series. An accompanying R package called monomvn has been made freely available on CRAN. 1