Variable selection for minimum-variance portfolios

Machine learning (ML) methods have been successfully employed in identifying variables that can predict the equity premium of individual stocks. In this paper, we investigate if ML can also be helpful in selecting variables relevant for optimal portfolio choice. To address this question, we parameterize minimum-variance portfolio weights as a function of a large pool of firm-level characteristics as well as their second-order and cross-product transformations, yielding a total of 4610 predictors. We find that the gains from employing ML to select relevant predictors are substantial: minimum-variance portfolios parameterized with a large set of predictors achieve lower risk relative to sparse specifications commonly considered in the literature, especially when non-linear terms are added to the predictor space. Our evidence suggests that ad-hoc sparsity can be detrimental to the performance of minimum-variance characteristics-based portfolios.