Portfolio Selection under Systemic Risk

Abstract

AbstractThis paper proposes a modified Sharpe ratio to construct optimal portfolios under systemic events. The portfolio allocation problem is solved analytically under the absence of short‐selling restrictions and numerically when short‐selling restrictions are imposed. This approach is made operational by embedding it in a multivariate dynamic setting using dynamic conditional correlation and copula models. We evaluate the out‐of‐sample performance of our portfolio empirically over the period 2007 to 2020 using ex post final wealth paths and systemic risk metrics against mean–variance, equally weighted, and global minimum variance portfolios. Our portfolio outperforms all competitors under market distress and remains competitive in noncrisis periods.