Statistical proxy based mean-reverting portfolios with sparsity and volatility constraints

Mean-reverting portfolios with volatility and sparsity constraints are of prime interest to practitioners in finance since they are both profitable and well-diversified, while also managing risk and minimizing transaction costs. Three main measures that serve as statistical proxies to capture the mean-reversion property are predictability, portmanteau criterion, and crossing statistics. If in addition, reasonable volatility and sparsity for the portfolio are desired, a convex quadratic or quartic objective function, subject to nonconvex quadratic and cardinality constraints needs to be minimized. In this paper, we introduce and investigate a comprehensive modeling framework that incorporates all the previous proxies proposed in the literature and develop an effective unifying algorithm that is enabled to obtain a Karush–Kuhn–Tucker (KKT) point under mild regularity conditions. Specifically, we present a tailored penalty decomposition method that approximately solves a sequence of penalized subproblems by a block coordinate descent algorithm. To the best of our knowledge, our proposed algorithm is the first method for directly solving volatile, sparse, and mean-reverting portfolio problems based on the portmanteau criterion and crossing statistics proxies. Further, we establish that the convergence analysis can be extended to a nonconvex objective function case if the starting penalty parameter is larger than a finite bound and the objective function has a bounded level set. Numerical experiments on the S&P 500 data set demonstrate the efficiency of the proposed algorithm in comparison to a semidefinite relaxation-based approach and suggest that the crossing statistics proxy yields more desirable portfolios.