risks

Review
A Review on Machine Learning for Asset Management
Pedro M. Mirete-Ferrer 1,2, *,† , Alberto Garcia-Garcia 3,† , Juan Samuel Baixauli-Soler 4 and Maria A. Prats 4
1 Escuela Internacional de Doctorado Universidad de Murcia, Interuniversity Doctorate in Economics
(DEcIDE), 30100 Murcia, Spain
2 Faculty of Economics and Business Administration (ICADE), Universidad Pontificia Comillas,
28015 Madrid, Spain
3 Departamento de Tecnología Informática y Computación, Universidad de Alicante, 03690 Alicante, Spain;
[email protected]
4 Facultad de Economía y Empresa, Universidad de Murcia, 30100 Murcia, Spain;
[email protected] (J.S.B.-S.); [email protected] (M.A.P.)
* Correspondence: [email protected] or [email protected]
† These authors contributed equally to this work.

Abstract: This paper provides a review on machine learning methods applied to the asset manage-
ment discipline. Firstly, we describe the theoretical background of both machine learning and finance
that will be needed to understand the reviewed methods. Next, the main datasets and sources of
data are exposed to help researchers decide which are the best ones to suit their targets. After that,
the existing methods are reviewed, highlighting their contribution and significance in the analyzed
financial disciplines. Furthermore, we also describe the most common performance criteria that are
applied to compare such methods quantitatively. Finally, we carry out a critical analysis to discuss
the current state-of-the-art and lay down a set of future research directions.

Keywords: finance; machine learning; asset management; portfolio management; factor investing






Citation: Mirete-Ferrer, Pedro M.,
Alberto Garcia-Garcia, Juan Samuel 1. Introduction
Baixauli-Soler, and Maria A. Prats.
During the last 70 years, financial economists over the world have dedicated great
2022. A Review on Machine Learning
efforts to model and forecast stock returns, trying to understand the patterns behind them.
for Asset Management. Risks 10: 84.
This has been the greatest challenge of the research focused on Asset Management over
https://doi.org/10.3390/risks
the last few decades. As Cochrane (2011) exposed, “In the beginning, there was chaos;
10040084
practitioners thought one only needed to be clever to earn high returns. Then came the
Academic Editor: Thorsten Schmidt CAPM. Every clever strategy to deliver high average returns ended up delivering high
Received: 9 January 2022
market betas as well. Then anomalies erupted, and there was chaos again. The ”value effect”
Accepted: 12 April 2022
was the most prominent anomaly”. In the last 10 years, the huge amount of anomalies
Published: 13 April 2022
found has driven the academic professionals to call the phenomenon as a “factor zoo”.
In contrast to this “anomaly-challenging” branch of literature, a growing amount of
Publisher’s Note: MDPI stays neutral
work indicates remarkable investment performance based on signals generated by various
with regard to jurisdictional claims in
Machine Learning (ML) methods. With the recent advancement in financial technology
published maps and institutional affil-
(Fintech), there is an increasing trend of employing ML technologies to find new signals on
iations.
price movements and build investment systems that can beat human fund managers from
the perspective of practical investment management. ML routines in academic research
have been implicitly motivated by the American Finance Association (AFA) presidential
Copyright: © 2022 by the authors.
address of Cochrane (2011). This author suggested that, in the presence of a large num-
Licensee MDPI, Basel, Switzerland. ber of noisy and highly correlated return predictors, there is a need for other methods
This article is an open access article beyond cross-sectional regressions and portfolio sorts. Indeed, ML uses “regularization”
distributed under the terms and approaches to choose models, moderate over-fitting biases, find complicated patterns and
conditions of the Creative Commons hidden linkages, and handle high-dimensional predictor sets and more flexible functional
Attribution (CC BY) license (https:// forms, as exposed by Gu et al. (2020).
creativecommons.org/licenses/by/ To illustrate the gap that still exists between academic finance and the financial in-
4.0/). dustry, with regards to the interest of the academic finance community for ML techniques,

Risks 2022, 10, 84. https://doi.org/10.3390/risks10040084 https://www.mdpi.com/journal/risks

Risks 2022, 10, 84 2 of 46

Huck (2019) carried out a very interesting experiment using the academic papers database:
until 2017, the search for “machine/deep learning” via the EBSCO database, produces no
reference at all in “The Journal of Finance”, the leading academic finance journal, and only
one reference in “The Journal of Financial Economics”. If we expand the analysis to some
other academic financial or economic journals, using an additional financial term as “stock
returns”, there can be found 21 references, mainly in “Quantitative Finance”. Other 64
references can be placed in non-financial journals. In the last four years, although the
interest of academic finance for ML techniques has apparently grown due to the movement
initiated by econometricians and statiscians, as mentioned by Heaton et al. (2016), the result
of this experiment is not so different, giving the result of 21 references within financial or
economic journals, and a hundred additional references outside them.
As Heaton et al. (2017) points out, the main difference between the use of ML tools in
Finance and other areas of Science is that, in Finance, “the emphasis is not in replicating
tasks that humans already do well. Unlike recognizing an image or responding appropri-
ately to verbal requests, humans have no innate ability to, for example, select a stock that is
likely to perform well in some future period”. For this reason, the usefulness of ML tools
for financial purposes should be searched somewhere else. Specifically, they are extremely
powerful in selection problems since, at their basis, they are the best and most rapid way
to compute any function mapping data, and that is what returns, prices, economic data,
accounting data, and so forth.
Our work aims to find a balance between finance, statistics, and computational dis-
ciplines by improving the analysis of recent literature from the standpoint of financial
economics using ML approaches, allowing academics and practitioners to locate their areas
of interest without gaps. We will formulate the asset management problem and break it
down into disciplines, providing the reader with enough background knowledge to either
get familiar with the area or acquire a standard terminology. The range of fields of our
paper will span all the topics related to asset/portfolio management, from asset pricing
and factor investing, more linked to economic and financial variables, to price forecasting
and algorithmic trading, more concentrated on price and volume data. Finally, we will
discuss the reviewed methods and datasets and provide useful insight in shape of future
research directions and open challenges in the field.
The paper is organized as follows. In Section 2, we provide an overview of the most
recent works of literature review in the field of ML applications to Finance. Furthermore,
we justify the usefulness of our approach versus the rest of review papers. In Section 3, we
expose the methodology and terminology to be used in the rest of the paper, as well as a
review of the basic theoretical background about Asset Management and ML techniques.
Section 4 gives a description of the different datasets used in the research. Section 5
provides a detailed description of the current state of the art in the application of ML to
Asset Management, using a double outlook to classify the recent literature: the financial
field of application and the ML empirical approach used. A discussion upon the evidence
presented in previous sections is presented in Section 6. Lastly, we conclude in Section 7
with the final remarks.

2. Related Works
In this section, we will review the recent literature that, in form of survey papers,
analyse the recent contributions regarding ML applications to Finance in general (Gen-
eral Surveys) and, later, to specific areas of Finance regarding Asset Management: price
forecasting, asset pricing and portfolio management.
Finance is an extremely diverse field in Economics, that includes so diverse disciplines
as Asset and Portfolio Management, Risk Assessment, Fraud Detection or Financial Regula-
tion, among many others. The use of machine learning techniques in all these fields, in the
recent years, has been increasingly relevant.
In the sample selected in this work, spanning the last five years, we have been able
to find fifteen papers, as it is shown in Table 1. From general to specific, the compilation
Risks 2022, 10, 84 3 of 46

papers adopting the scope of general applications of machine learning to finance, in its
widest extension, is relatively popular, with four papers in the last five years. Among the
specific review papers, which are focused on some of the application areas of Finance,
the discipline related to price forecasting and time-series prediction counts for more than a
half of the total, with eight papers. We can also find one general review about asset pricing
and value investing. And finally, the asset and portfolio management discipline and its
applications has a main role in two papers of revision, one of them exclusively focused
on online portfolio selection. In most cases (12 out of 15), as it can be seen in the second
column, the publishing journals were computer science outlets.

Table 1. List of review articles in the last five years, both general and specific financial areas.
General Survey (GS), Price Forecasting (PF), Asset Pricing (AP), Portfolio Management (PM), Stock
Market (SM), Exchange Rates forecasting (FX), Interest Rate forecasting (IR), Criptocurrencies (CC),
Commodity Prices (CP), Derivatives (DV), Real Estate (RE). Applied Soft Computing Journal (1),
Expert Systems with Applications (2), Artificial Intelligence Review (3), Frontiers of Business Research
in China (4), International Journal of Electricity and Computer Engineering (5), International Journal
on Emerging Technologies (6), Financial Markets and Portfolio Management (7), ACM Computing
Surveys (8), ICEFR 2019 (9). (∗) for financial journals or conferences.

Author Journal/Venue Period Citations References Area Market

Ozbayoglu et al. (2020) 1 2014–2018 44 196 GS SM, CC, DV
Huang et al. (2020) 4* 2014–2018 13 51 GS SM, FX, CP
Tkáč and Verner (2016) 1 1994–2015 184 425 GS SM, FX, IR, DV
Cavalcante et al. (2016) 2 2009–2015 282 144 GS SM, FX, DV
Sezer et al. (2020) 1 2005–2019 162 216 PF SM, FX, CP
Henrique et al. (2019) 2 1991–2017 101 98 PF SM
Bustos and P.-Quimbaya (2020) 2 2014–2018 24 87 PF SM
Kamley et al. (2016) 5 2000–2015 13 68 PF SM
Jiang (2021) 2 2017–2019 39 234 PF SM
Nti et al. (2019) 3 2017–2019 36 207 PF SM
Xing et al. (2018) 3 1998–2016 157 153 PF SM
Durairaj and Mohan (2019) 6 1999–2019 15 46 PF SM, FX, IR, DV
Weigand (2019) 7* 1994–2018 8 49 AP SM, IR, DV, RE
Emerson et al. (2019) 9* 2015–2018 1 81 PM SM
Li and Hoi (2014) 8 1991–2013 137 246 PM SM

2.1. General Surveys

A general survey about the recent applications of Deep Learning in Finance was
conducted in Ozbayoglu et al. (2020). The authors chose to separate the most significant
section of computational intelligence for finance research, which is focused on financial
time-series forecasting, from this analysis. Their findings show that financial text min-
ing, algorithmic trading, risk assessment, sentiment analysis, portfolio management and
fraud detection are among the most-studied areas of finance research, and that Recurrent
Neural Network (RNN)-based models (in particular, Long-short Term Memory (LSTM)),
Convolutional Neural Networks (CNNs) and Deep Multi-layer Perceptron (DMLP) have
been used extensively in implementations.
We can find that another recent paper, Huang et al. (2020), also focused on Deep
Learning techniques with a general perspective of Finance and Banking. They defined
seven domains of financial applications, which are: exchange rate prediction, stock market
prediction, stock trading, banking default risk and credit, portfolio management, macroeco-
nomic prediction, and oil price prediction. In their classification there is a predominance of
price forecasting fields, and there exists a mixture of financial and banking disciplines.
The last two references that can be considered as review papers from a general fi-
nancial perspective that were written in 2016. The paper by Tkáč and Verner (2016) is
generally from the point of view of the fields of application, but specific in the methods
used by the papers reviewed, that must have been focused on neural networks. More than
400 articles are classified according to the year of publication, application area, type of
neural network, learning algorithm, benchmark method, citations, and journals. Lastly,
Risks 2022, 10, 84 4 of 46

in Cavalcante et al. (2016), the financial review of the literature was organized according to
their primary goal or main contribution to computational intelligence applied to financial
markets literature. Following this criteria, papers are classified in application fields such as
preprocessing mechanisms, forecasting models, and text mining and forecasting mechanisms.

2.2. Price Forecasting

As we previously mentioned, price forecasting has been the most prolific area of
application of machine learning algorithms in the finance industry over the last few years.
We have been able to find and classify six review papers fully devoted to price forecasting
techniques, most of them focused on the stock market. As Ozbayoglu et al. (2020) describes,
the most substantial portion of computational intelligence for finance research is dedicated
to financial time-series forecasting, and this statement can be fully transferred to the field
of review papers.
From the same authors, there exists a review paper fully focused on price forecast-
ing Sezer et al. (2020). Their motivation was to provide a comprehensive literature review
on Deep Learning (DL) studies for financial time-series forecasting implementations. They
not only categorized the studies according to their intended forecasting implementation
areas, such as index, forex, and commodity forecasting, but also grouped them based on
their DL model choices, such as CNNs, Deep Belief Networks (DBNs), and LSTM. They
found that RNN-based models (in particular, LSTM) are the most commonly used mod-
els, whilst Natural Language Processing (NLP), semantics and text mining-based hybrid
models ensembled with time-series data might be more common in the near future.
The survey paper by Henrique et al. (2019) proposes the use of bibliographic survey
techniques to classify around 60 papers about this issue. The authors reach two relevant
conclusions: (1) the prevalence of Support Vector Machines (SVMs) and Neural Networks
(NNs) as the most commonly used techniques, and (2) the relevance that the use of data
from developing markets might have in the future. A more updated, but similar approach,
comes from Bustos and P.-Quimbaya (2020), which aims to perform an updated systematic
review of the forecasting techniques used in the stock market. The paper includes a long list
of review papers in Finance, where the relevance of text mining techniques in this financial
field emerges clearly. It addresses the classification of papers according to two criteria:
the type of inputs (market information, technical indicator, economic indicators) and the
technique or method used in the research.
Additionally involved in the stock price forecasting domain, we can find Kamley et al.
(2016), which provides an overview of the machine learning techniques that have been
used to forecast equity performance. The most distinct contribution of this paper has to
do with the procedure to know how the prediction algorithms can be used to identify the
most important variables in an equity market data set. The methods reviewed from the
literature are Decision Trees (DTs), NNs, SVM, Genetic Algorithms (GAs), and Bayesian
Networks (BNs). More recent are the contributions from Jiang (2021), specifically in the
subfield of deep learning techniques, not only by categorizing the different data sources,
various neural network structures, and commonly used evaluation metrics, but also their
implementation and reproducibility. Finally, we can find Nti et al. (2019), where authors
focused on fundamental and technical analyses, finding that SVM and Artificial Neural
Network (ANN) are the most popular techniques of ML for stock market prediction.
The last two surveys about price forecasting are clearly more specific. In Xing et al.
(2018), we can find a study about NLP, a pragmatic research viewpoint of computer linguis-
tics that has grown in capability as a result of data availability and different methodologies
developed over the last decade, and the subfield which aims to predict financial mar-
kets, the Natural Language-based Financial Forecasting (NLFF). This work includes recent
attention in markets to sentiment analysis or event extraction. In Durairaj and Mohan
(2019), a review of deep learning hybrids for financial time-series prediction can be found.
According to the authors’ definition, a hybrid forecasting model combines two or more
Risks 2022, 10, 84 5 of 46

stand-alone forecasting models into a combined model in the hope to improve prediction
accuracy and overcome the deficiencies of stand-alone models.

2.3. Value/Factor Investing

Accurate pricing or valuation of an asset can be considered as a fundamental area of
research in Finance. As we will describe in Section 5, the asset pricing models have become
one of the more prolific areas of study in Finance within the last 50 years. Although it is not
a simple task to draw a division line between this area of study and others, mainly asset
and portfolio management, we thought that it would be convenient to establish a separate
field for all those papers and techniques which are aimed at finding the best representation
models and forecasts for asset prices and returns (asset pricing models), but not involved
in the process of combining those return forecasts with risk models in order to create an
optimum portfolio, given an investor’s constraints (portfolio management).
According to our classification criteria, only one paper can be considered as a literature
review in the field of asset pricing/value investing. It is the work by Weigand (2019),
where the author suggests that ML can aid future study, but that academics should be
skeptical of these approaches because ML has flaws and is still relatively new to asset
pricing. This literature review summarizes the research in fields like equities, global equity
indices, derivatives, real estate appraisals, and bonds, as well as mortgage delinquencies.
The authors conclude that these ML approaches show potential in overcoming deficiencies
of traditional methods in empirical asset pricing, characterized by the general problems of
prediction, variable selection, as well as the definition of a suitable functional form.

2.4. Portfolio Management

Finally, some of the survey papers about ML applied to Finance in the last few years
are devoted to portfolio optimization. Despite the relevance that this discipline has reached
in recent years in the banking industry, we have been able to find, in the last five years, only
one survey, and we had to expand our focus and go back seven years to find the second. In
Emerson et al. (2019), the authors evaluated current and potential applications of ML to the
investment process. In particular, they included the development of ML applications for
return forecasting, portfolio construction, and risk modelling, which are framed under the
general category of Quantitative Finance and, more specifically, the investment process.
They identified 67 papers from different perspectives, focused on those three core areas
regarding the investment process. The analysis and discussion of the recent literature about
them was then made individually for each of the previously identified papers.
The second reference about portfolio management, previously mentioned, was written
seven years ago. In Li and Hoi (2014), the authors provided a comprehensive survey of
online portfolio algorithms selection, the asset management field that sequentially selects a
portfolio over a set of assets in order to achieve certain targets. The authors concentrate on
a survey of multiperiod/sequential portfolio selection work due to the sequential (online)
character of this assignment, in which the aim is to maximize the expected log return across
a sequence of trading periods, and the portfolio is rebalanced to a set allocation at the
conclusion of each trading session.

2.5. Our Proposal in Context

After analyzing the different survey papers written in the last five years, we have
reached the following conclusions:
• Finance is an extremely diverse field in Economics, that includes such diverse disci-
plines as Asset/Portfolio Management, Risk Assessment, Fraud Detection or Financial
Regulation. The use of ML techniques in all these fields, in the recent years, has been
increasingly relevant. Most of the literature reviews have tried to span every single
discipline within this extensive and heterogeneous group, so that the analysis has been
revealed, in some occasions, as relatively superficial. In some other cases, the classifi-
cation has been quite arguable because of the dominance of price forecasting fields,
Risks 2022, 10, 84 6 of 46

and the mixture of financial and banking disciplines. Maybe due to this extensive strat-
egy adopted by their peers, some authors have adopted the reverse approach, focusing
the revision on a single ML methodology, achieving an arguable result extensive in
financial disciplines but excessively focused on a single ML technique.
• Within the financial disciplines related to asset management, price forecasting has
been the favourite field of review papers in the last five years. Favored by this wide
coverage, researchers and practitioners that are interested in this topic can decide
which path they should take according to currently existing literature.
• In terms of popularity, asset pricing is the antithesis of price forecasting. Only one
review paper Weigand (2019) is concentrated on this financial field, which can be
considered as the conceptual basis of the rest of the disciplines.
• Similarly, portfolio management reviews are clearly underrated. Just one paper
Emerson et al. (2019) in the last five years can be considered as a general survey about
this topic.
According to previous analysis points, we think our paper bridges a gap in the area of
review papers and makes the following useful contributions:
• It covers a very understated field in the surveys’ literature, despite the growing
relevance that this financial discipline has reached in recent years in the banking
industry. The range of fields of our paper spans all the topics related to asset/portfolio
management, from asset pricing and factor investing, more linked to economic and
financial variables, to price forecasting and algorithmic trading, more concentrated on
price and volume data.
• Our paper tries to find an equilibrium point between finance, statistics and compu-
tational fields, enhancing the analysis of the recent literature from the perspective of
financial economics, as well as ML methods, so that researchers and practitioners can
find their areas of interest without gaps. We dedicate a section to analyzing the quality
and homogeneity of datasets, a somewhat neglected aspect in finance, unlike other
scientific fields. Similarly, we make an analysis of the different approaches adopted in
the recent literature regarding the performance criteria.
• Beyond the gathering, processing, and classification of papers and information, our
work gives responses to several research questions, such as areas of interest to the
financial and ML community, degree of maturity of the existing research in each
of the application areas, areas with more promising potential from academic and
industrial perspectives, and suggestions about future directions for ML research in
asset/portfolio management.

3. Theoretical Background
This section includes all the methodology and terminology to be used in the rest of
the paper. ML applications in Finance is a field that can be included in the discipline of
Quantitative Finance. On the one hand, it includes a review of the basic financial theoretical
background, from the definitions of the different financial disciplines to the empirical asset
pricing models, passing by the well-known theoretical asset pricing models as Capital
Asset Pricing Model (CAPM), APT, and so forth. On the other hand, this section introduces
the main theoretical principles about ML, mainly those connected with asset and portfolio
management in a wide sense. Finally, it includes a review and description of the main
indicators of performance used in the literature of ML applications to Asset Management,
very related to reproducibility issues.

3.1. Financial Background

According to Snow (2020), the Asset Management discipline can be divided “into
four streams: portfolio construction, risk management, capital management, infrastructure
and deployment, and sales and marketing”. We will focus our work on the first stream,
portfolio construction, which is intimately tied with the investment process. Portfolio
Risks 2022, 10, 84 7 of 46

construction is divided, in turn, into four areas: price forecasting, event prediction, value
investing, and weight optimization.
The first three areas can be included in the field of trading strategies, but they differ in
the type of data used and the outcome they are trying to predict. Price strategies include
technical analysis, and macro global and statistical arbitrage (also called pairs trading),
and the price plays a starring and lonely role. Right in the opposite corner, we can place
value investing strategies, where the relationship between value and price is what generates
the investment opportunities. Examples of these types of strategies are risk parity, factor
investing, and fundamental investing. Finally, event strategies can be considered as part
of a relatively new stream: an event-driven strategy refers to an investment strategy in
which an investor attempts to profit from a stock mispricing that may occur during or after
a corporate event. The theoretical basis of all of them, one way or another, can be found
in the Asset Pricing theory, although in the case of price strategies, the relevance of the
concept of value decays notably.
The fourth area, weight optimization, can be considered independently from the
other three areas. It comprises the use of mathematical or statistical techniques to solve
optimization and simulation problems in finance, like optimal execution, position sizing,
and portfolio optimization.
Due to the extreme complexity and variety of disciplines included in the term of
Asset Management, we have decided to define our own structure of disciplines to face
the gathering, processing, classification and analysis of recent literature. We will divide
the asset management disciplines into three main streams: value investing and price
forecasting, as trading strategies topics, and portfolio management as an independent area
which involves optimization. Value investing will comprise all the disciplines which use
asset pricing models to select the most valuable assets to invest in. The most relevant and
recent example of this type of discipline is factor investing. Price forecasting, on the other
hand, will comprise all the financial areas focused on the best prediction of asset prices. We
will open a special category in Section 5 for algorithmic trading, the most relevant area of
price strategies in recent literature. Lastly, following the proposal from Snow (2020), weight
optimization will be defined as an independent discipline that, for our purposes, will be
categorized as portfolio management.
In short, these will be the three financial disciplines that will be used in the rest of
the article:
1. Value/factor investing. Investment strategies which use asset pricing models to select
the most valuable assets to invest in.
2. Price Forecasting. Investment strategies focused on the best prediction of asset prices.
Algorithmic trading can be considered as a special case of price strategy.
3. Portfolio Management. Mathematical and statistical techniques which solve optimiza-
tion and simulation problems in investment management.

3.1.1. Value/Factor Investing

Over the past three decades, hundreds of financial research articles have been dedi-
cated to the study of asset pricing models with a dual purpose: on the one hand, to analyze
the behavior of asset prices and, on the other hand, to try to find variables that contain
information about them. The advances in financial research about asset pricing and quanti-
tative methods about factor investing have been crucial for the exceptional development
of the Asset Management industry in general and the enhancement of the investment
processes, specifically.
Throughout this section, we will analyze both theoretical and empirical models. This
body of knowledge is usually applied to cross-sectional data, that is, data from different
financial assets at the same period of time. When this occurs, we will use the sub-index
i. When we apply the models to data which vary over time, that is, time-series data, we
will use the sub-index t. The coexistence of both dimensions, cross-section and time-series,
is traditionally solved in Econometrics through panel data methodology but, specifically
Risks 2022, 10, 84 8 of 46

in factor investing, this double dimension is faced through the methodology of Fama and
Macbeth (1973).

SDF as General Source of Asset Pricing Models

Regardless of the type of asset pricing models we use, all of them can be deduced from
the general Stochastic Discount Factor (SDF) Model, also known as the Euler Equation.
The SDF, also denominated as the pricing kernel, allows one to relate the current price
of an asset to its future payoffs. The roots of this type of representation are based on the
Arrow–Debreu model of general equilibrium, and its application to option pricing (Cox
and Ross (1976) and Ross (1978)), along with the Asset Pricing Theory (APT) of Ross (1976).
Using the same notations as Cochrane (2000), xt+1 will represent an asset pay-off at
date t + 1, pt the asset price at date t, and mt+1 the SDF at date t + 1. The fundamental
equality states that:
Pt = Et (mt+1 Xt+1 ) (1)
Equation (1) indicates that the asset price is equal to the conditional expected value of
the future payoff multiplied by the SDF, which is a random variable whose realizations
are always greater than zero. The expected price can be understood, hence, as a weighted
average of future payoffs in different states of the economy, where each state has a proba-
bility of occurrence defined by its SDF. Consequently, the SDF is simply a discount factor
that transforms expected payoffs tomorrow into value today, but in a world of uncertainty;
if there is no uncertainty or if investors are risk-neutral, the SDF is merely a constant that
transforms expected payoffs tomorrow into value today. 1
The asset pricing model which allows to make a direct translation of the SDF architecture
into a model with observable variables is a consumption-based Model where the SDF is
derived from the optimality conditions for a single agent. The very well-known Consumption-
based Capital Asset Pricing Model (CCAPM) from Breeden (1979) (see Section 3.1.1) can be
regarded as an equilibrium version with multiple investors of this seminal model. 2
The major contributions of the stochastic discount factor approach are its simplicity
and universality. Instead of using three apparently different theories for different types of
assets, for example, bonds, stocks, and derivatives, we can consider them as just special
cases of the same theory.

Theoretical Factor Models

In Cochrane (2000), the author demonstrated that formulating a factor model in terms
of the SDF is equal to a "beta representation" of expected returns, which is more common
across different factor model formulations. Therefore, SDF model can be translated into
a factor model, that is, a linear function of some risk factors, which discounts uncertain
payoffs differently across different states of the world. Factor models correct the limitations
of the unobservable SDF and the restrictions of a consumption-based approach, bearing in
mind that consumption is a macroeconomic aggregate that is provided with lags and is
continuously revised.
A factor model suggests the existence of a scalar a and a K × 1 vector b as loadings for
a K × 1 vector f of factor values, such that the quantity described by:

m = a + biT f i i = 1, 2, ..., K (2)

is an SDF. A factor f k (the k-th factor) that has a non-zero loading bk is known as a “pric-
ing factor”.
Let us assume that f is a K × 1 random vector. Thus, a scalar a and a K × 1 vector b
exist such that Equation (2) prices all assets if, and only if, a scalar κ and a K × 1 vector Λ
exist such that for each asset i, the expected return Ri is:

E[ Ri ] = κ + ΛiT β i i = 1, 2, ..., K (3)

Risks 2022, 10, 84 9 of 46

where the K × 1 vector β i is the vector of multivariate regression coefficients of Ri on f

with a constant.
As Cochrane (2000) explains in his book, “b j (vector b) coefficients asks whether factor
j helps to price assets given the other factors. b j gives the multiple regression coefficient
of m on f j given the other factors. On the contrary, λ j (components of vector Λ) asks
whether factor j is priced, or whether its factor-mimicking portfolio carries a positive risk
premium”. λ j gives the single regression coefficient of m on f j . Therefore, when factors are
correlated between them, one should test b j = 0 to see whether to include a factor j given
the other factors rather than test λ j = 0. Multiple authors consider that, when we are able
to find a factor whose risk premium is non-zero (λ j 6= 0), we can call it a “priced factor” or
characteristic and, when we are able to find a factor that has a non-zero coefficient b j , we
can call it a “pricing factor”.
When confronted with a factor model, a fundamental question arises: which are the
genuine pricing factors? We will go over the theoretical factor models that can be used to
solve this question.
• Static CAPM. The CAPM of Sharpe (1964) and Lintner (1965) is an equilibrium model
in which the excess return on the market portfolio is the only pricing component. As a
result, the model predicts that every asset’s projected excess return is proportionate to
its market beta.
E[ Ri,t ] = Rdt + βm m d
i ( E [ R t ] − R t ), (4)
Rdt being the risk-free rate, Rm
t the return on the market portfolio, and β im the beta of
the asset i with respect to the market.
• Intertemporal CAPM. By allowing for various time horizons and preferences among
investors, Intertemporal Capital Asset Pricing Model (ICAPM) of Merton (1973) re-
laxes some assumptions of the static CAPM. Asset risk premia are linear functions of
the market beta and other betas in terms of factors. As a result, the market factor is
really not the exclusive determinant of pricing any longer.

K −1
µi,t − Rdt = βm m d
i,t ( µt − Rt ) + ∑ βki,t (µkX,t − Rdt ) (5)
k =1

where µm k
t is the expected return on the market portfolio, and µ X,t is the expected
return on the portfolio that maximizes the squared correlation with the k-th state
variable.
• Consumption-Based CAPM. The ICAPM in its seminal form calls for determining the
variables that influence the opportunity set’s evolution. In Breeden (1979), the author
introduced a CCAPM that substitutes the multiple betas in the decomposition of
expected returns by a single beta, which reflects changes in aggregate consumption.
The assumptions are the same as in Merton’s ICAPM.
Breeden (1979) shows that expected excess returns are given by:

µC d
t − Rt C
µi,t − Rdt = β i,t i = 1, 2, ..., N (6)
βCC,t

where βCi,t is the beta of asset i with respect to aggregate consumption C, βCC,t is the
beta of the portfolio that maximizes the squared correlation with changes in aggregate
consumption, and µC t is the expected return on this portfolio.
• Arbitrage Pricing Theory. APT from Ross (1976), along with CAPM, is one of the
most influential theories on asset pricing. The APT varies from the CAPM in that its
assumptions are less restrictive. The APT concentrates on return factor decomposition:
statistical description of asset returns as linear combinations of K common factors and
a random disturbance serves as its foundation.
If Xi indicates the pay-off of an asset, then we have:
Risks 2022, 10, 84 10 of 46

Xi = E[ Xi ] + β Ti f + ei , i = 1, 2, ..., N (7)
where the idiosyncratic return is uncorrelated from the factors. Such a decomposition
of factors is always satisfied, since it is always possible to make a regression for a
payoff on a given set of factors. Statistically, it is necessary to assume that there is no
autocorrelation in the residuals ei across assets.

Empirical Factor Models

Early work on the Sharpe–Lintner CAPM tended to be broadly supportive. In the
1970s, the classic studies of Black et al. (1972) and Fama and Macbeth (1973), found that,
empirically, the high-beta stocks tended to have higher average returns than low-beta
stocks and that the relation was roughly linear. During the 1980s and 1990s, researchers
began to look at other characteristics of stocks besides their betas. All those deviations from
the original CAPM were called “anomalies”, due to the fact that there did not exist any
kind of theoretical model able to explain the existence of those kinds of factors. Empirically,
all these anomalies may be explained more efficiently by utilizing multifactor models in
which the factors are chosen based on empirical evidence, rather than theoretical support.
• Size and value factors. The empirical evidence that small-cap equities perform better
than large-cap equities is known as the size effect. Van Dijk (2011) made an extensive
survey of 30 years of research in equity returns. As the author recognizes, this addi-
tional factor in CAPM was primarily introduced by Fama and French (1992) with their
three-factor model, and since then, “there has been a vigorous debate on whether the
size premium is a compensation for systematic risk”.
The size factor is represented as the excess return of small caps over large caps.
Fama and French (1992) introduced a “Small–Minus–Big” (SMB) portfolio, which is a
zero-investment portfolio built as the difference between the average return on three
small-cap portfolios and that on three large-cap portfolios, which has been ordered,
previously, according to the book-to-market ratio (Value, Neutral and Growth). This
previous filter is defining the third factor, “High-Minus-Low” (HML) of their model,
which is another zero-investment portfolio built as the difference between the average
return on two value stock portfolios and that on two growth stock portfolios, according
to the size quantiles (Big and Small).
The three-factor model by Fama and French (1992) was expressed as follows:

E[ Ri,t ] = Rdt + βm m d SMB

i ( E[ Rt ] − Rt ) + β i SMBt + β iHML HMLt + ei,t (8)

Rdt being the risk-free rate, Rm m

t the return on the market portfolio, β i the beta of the
SMB
asset i with respect to the market factor, β i the beta of the asset i with respect to the
size factor, and β iHML the beta of the asset i with respect to the value factor.
• Momentum factor. Beyond the size and value factors, the momentum factor is the most
prevalent factor in the literature. Momentum can be defined as the rate of acceleration
of a security’s price, and simply, it refers to the inertia of a price trend to continue
either rising or falling for a particular length of time. The trading strategies related to
this effect, as we will see in the next Section 3.1.2, also called “trend following”, seek
to capitalize on momentum to enter a trend as it is picking up steam. In statistical
terms, the momentum effect characterizes by the existence of serial autocorrelation.
The paper by Carhart (1997) can be considered as a study about this matter which,
in the last few years, has received more acknowledgement from the investment indus-
try. The author provides evidence in this research which focuses on the mutual fund
business, that strong previous performance does not necessarily imply future returns,
but that the contrary might be true (if the performance is based on loading up on spe-
Risks 2022, 10, 84 11 of 46

cific risk factors). This paper presents a four-factor model with the three factors from
Fama and French (1992), plus a new factor which represents the momentum effect:

E[ Ri,t ] = Rdt + βm m d SMB

i ( E[ Rt ] − Rt ) + β i SMBt + β iHML HMLt + βW
i
ML
W MLt + ei,t (9)

βWi
ML being the beta of the asset i with respect to the momentum factor. The WML

factor is defined as the excess return of an equally-weighted portfolio for 30% of past
winners over an identical portfolio of the 30% past losers (“Winners-Minus-Losers”).
• Profitability and Investment factors. Following the release of the five-factor model
from Fama and French (2015), these two components have lately gained a lot of
traction in stock investment techniques. This model was expressed as follows:

E[ Ri,t ] = Rdt + βm m d SMB

i ( E[ Rt ] − Rt ) + β i SMBt +
+ β iHML HMLt + β iRMW RMWt + βCMA
i CMAt + ei,t (10)

β iRMW being the beta of asset i with respect to the profitability factor, and βCMA
i the
beta of asset i with respect to the investment factor.
The procedure to estimate these two new factors is similar to previous factors in Fama
and French (1992). Stocks are first sorted according to a measure of profitability or
investment. The profitability factor is the excess return of robust profitability stocks
over weak profitability ones (“Robust-Minus-Weak” or RMW factor), while in the
case of the investment factor, it is defined as the excess return of high-investment
stocks over low-investment ones (“Conservative-Minus-Aggressive” or CMA factor).
The authors choose as measures the operating profit after interest expenses and the
growth of total assets, respectively.

3.1.2. Price Forecasting

The price forecasting discipline can be defined as the financial area which aims to
predict the future price of an asset using market data and its transformations. Some
examples of this kind of strategy are trend trading strategies, where one takes a position
in the asset only after predicting a change in trend, and statistical arbitrage, which seeks
mispricing by detecting asset relationships and/or potential anomalies, believing the
anomaly will return to normal. Algorithmic Trading, a financial discipline on the rise in
recent years, can be included within trend-following methods, so that, from a theoretical
perspective, they can be connected to price forecasting methods.
In this discipline, asset prices play a central and lonely role, while asset pricing
models and economic/financial fundamentals stay in a very secondary term. Sometimes,
the academic approach to price forecasting has not taken into account risk-related issues
or, directly, has not been interested in finding explanatory variables of risk, but in the best
prediction of prices. Shortly, the studies have been more interested in the predicting power
of modeling than in the explanatory power and economic meaning of the variables included
in the model. In the case of technical and trend strategies, the main theoretical topic has to
do with the accomplishment of Efficient Market Hypothesis (EMH) that we will expose in
the next few lines. Although statistical arbitrage strategies are also very related to EMH and
autocorrelation issues, they are connected, to some extent, to theoretical issues previously
explained in the Value Investing section, related to asset pricing and anomaly-seeking.
Regardless of the type of approach, time-series data analysis is prevalent in this
financial discipline, unlike the previous one, value investing, in which cross-sectional data
were clearly predominant.
The EMH states that asset prices always reflect all available information. A direct
implication is that it is impossible to “beat the market” consistently on a risk-adjusted
basis, since market prices should only react to new information, which can be considered
as a crucial implication for the asset management industry, mainly in the case of price
forecasting. The EMH is linked to the random walk theory, which defends that the best
prediction for tomorrow’s price is the current price.
Risks 2022, 10, 84 12 of 46

The validity of the random walk hypothesis and, as a result, the unpredictability of
asset returns were early concerns for jobs that faced the existence of the momentum effect in
stock prices (see previous section). An example of this kind of approach, which uses time-
series data, is Lo and MacKinlay (1988). From the perspective of cross-sectional data, we can
find Jegadeesh (1990), where authors examine the performance of stock selection techniques
based on prior monthly returns. Despite the fact that this anomaly was discovered after the
size and value effects, already exposed in previous section, institutional investors have a
long and reliable history with the momentum approach Asness et al. (2014).
The fundamental model of asset pricing, the SDF model, may explain how efficient
markets are (or are not) connected to random walk theory. This model, as mentioned in
the preceding section, makes mathematical predictions about a stock’s price assuming
that there is no arbitrage, that is, assuming that there is no risk-free way to successfully
trade. Formally, if arbitrage is impossible, the model predicts that a stock’s price will be the
discounted value of its future price. We may rewrite the Equation (1) if we imagine we live
in a world without dividends or, to be more limiting, if we assume we are functioning in
the short term and no dividend is paid:

Pt = Et (mt+1 Pt+1 ) (11)

Note that this equation does not generally imply a random walk. However, if we
assume the SDF is constant 3 , we have:

Pt = mEt ( Pt+1 ) (12)

Taking logs and assuming that Jensen’s inequality term is negligible, we have:

log Pt = log m + Et (log Pt+1 ) (13)

which implies that the log of stock prices follows a random walk (with a drift).
Regardless the type of asset pricing model we use, the EMH will be satisfied only
under some restrictive assumptions. As Cochrane (2000) points out, “’If investors are risk-
neutral, returns are unpredictable, and prices follow martingales (random walk process).
In general, prices scaled by marginal utility are martingales, and returns can be predictable
if investors are risk averse and if the conditional second moments of returns and discount
factors vary over time. This is more plausible at long horizons”.
As Timmermann and Granger (2004) points out, “The EMH is a backbreaker for
forecasters”, because in its crudest form it effectively says that returns from speculative
assets are unforecastable. That may appear to be the conclusion of the narrative from an
intellectual standpoint. Despite the strength of the argument, it does not appear to be
fully compelling to many forecasters. The reason is that, despite its simplicity, the EMH is
surprisingly difficult to test and considerable care has to be exercised in empirical tests.

3.1.3. Portfolio Management

Portfolio management is the financial discipline of which its basic goal is to establish
the optimal weight of each asset by simultaneously maximizing expected return and
minimizing risk. Better portfolio optimization models have a more efficient frontier, which
can help investors get a greater expected return while taking the same risk. As a result,
developing a more efficient portfolio optimization model has become a hot issue in the field
of investment management. The main framework which can be considered as a foundation
of portfolio management is the seminal work from Markowitz (1952), also known as the
Modern Portfolio Theory.
The modern portfolio theory (MPT), often known as mean-variance optimization
(Mean-variance optimization (MVO)), is a mathematical framework for constructing an
asset portfolio that maximizes expected return for a given degree of risk. It is a formalization
and extension of the concept of diversification in investment, which holds that having a
Risks 2022, 10, 84 13 of 46

variety of financial assets is less hazardous than owning only one. Its basic concept is that
an asset’s risk and return should not be assessed by itself, but rather on how it adds to the
overall risk and return of a portfolio. The volatility of asset prices, measured in terms of
standard deviation of returns, is used as a risk proxy.
For a portfolio consisting of m assets with expected returns µi , let wi be the weight of
the portfolio’s value invested in asset i such that ∑im=1 wi = 1, and let w = (w1 , ..., wm ) T ,
µ = (µ1 , ..., µm ), 1 = (1, ..., 1) T . The portfolio return has mean w T µ and variance w T ∑ w,
where ∑ is the covariance matrix of the asset returns; see Lai and Xing (2008). Given a
target value µ∗ for the mean return of a portfolio, Markowitz characterizes an efficient
portfolio by its weight vector we f f that solves the optimization problem:

we f f = arg minw w T ∑ w
subject to : w T µ = µ∗ , w T 1 = 1, w > 0 (14)

If portfolio return variance, rather than standard deviation, were plotted horizontally,
the inverse of the slope of the frontier would be q at the point on the frontier where the
inverse of the slope of the frontier would be q. On q, the entire frontier is parametric.
Markowitz (1952) developed a specific procedure for solving the above problem, called
the critical line algorithm, that can handle additional linear constraints, upper and lower
bounds on assets, and which has been proven to work with a semi-positive definite covari-
ance matrix.

3.2. Machine Learning Background

As we have previously described, since the financial crisis of 2008, many quantitative
factor models have failed and many conventional factors have become unprofitable Feng
et al. (2019). As a result, some market players are seeking for alternatives to standard
stock-picking methods.
Many practitioners started building hand-crafted models that can dynamically learn
from past data, as popular quantitative elements have become less credible. For many years,
investors have relied on econometric approaches, but only a handful have had success
using dynamic models based only on these techniques. This might be due to various factors:
(1) inherent noise in financial data, (2) the fact that factors can be multicolinear, and (3) that
connections between variables and returns can be changeable, non-linear, and contextual.
These properties make estimating any dynamic connections between possible predictors
and expected returns problematic for traditional models.
Given those limitations of hand-crafted methods, the use of ML techniques that
automatically learn the best features from data has become widespread to avoid them. Gu
et al. (2021) made the effort to concentrate all the elements involved in the ML techniques
to give a context-specific definition of ML: “A diverse collection of high-dimensional
models for statistical prediction, combined with so-called regularization methods for model
selection and the mitigation of overfitting, and efficient algorithms for searching among a
vast number of potential model specifications”.
These kind of methods have proven to be extremely successful in other disciplines
(like image processing or NLP). Part of that success is due to their ability to generalize to
unseen data, learn from noisy distributions, and automatically learn features for complex
data. In other words, they excel in those areas where classical domain-specific approaches
crafted by experts have found limitations. This meteoric rising of ML applications is mainly
due to the fact that, over the last decade, a series of enhancements have enabled recent
advances in practical ML and unlocked its utility: increased computing power, increased
data availability, and novel optimization techniques and architectural breakthroughs.
The most promising ML applications in finance are on the buy-side, focusing on
finding predictive signal among the noise and capturing alphas 4 . Some example applica-
tions are: time-series forecasting, market segmentation, regime-switching detection and,
of course, asset management, which is the main issue of this work.
Risks 2022, 10, 84 14 of 46

Nevertheless, as Arnott et al. (2019) points out, it is important to bear in mind the
very special characteristic of financial markets, they reflect the actions of people, which
may be influenced by others’ actions and by the findings of past research. Unlike other
scientific disciplines, research can influence future actions of economic agents. In many
respects, the problems that ML faces are just a continuation of the long-standing concerns
that quantitative finance experts have always confronted. While investors must exercise
caution, perhaps even more caution than in previous implementations of quantitative
methods, these new tools have a wide range of financial applications.
ML has been successfully applied to virtually any existing scenario where data are
available and useful information can be learned from it. However, different techniques
must be applied depending on the problem at hand. There are three main paradigms which
are characterized by the nature of the problem:

3.2.1. Supervised Learning

The dataset D contains samples xi together with their expected outputs yi , such as a
dog image together with its label “dog”, so D = {( x1 , y1 ), ..., ( xn , yn )}. Therefore, a function
f maps each sample to its output f ( xi ) = yi . The goal of supervised learning is to find
the best function approximation g ≈ f that meets two important criteria: (1) minimizes
the difference between known samples g( xi ) ∼ f ( xi ) = yi , and (2) generalizes properly to
samples xo which are not part of D.
The following are the the most prominent classical supervised learning methods
employed in finance:
• Least Squares Levenberg (1944): A method typically employed to find a linear regres-
sion by finding the best fit in the least squares framework, that is, minimizing the sum
of squared residuals.
• LASSO Tibshirani (1996): A form of linear regression that is characterized for using
shrinkage. This means that LASSO performs L1 regularization to penalize the absolute
value of the magnitude of the coefficients. As a result, typically a sparse set of
coefficients is produced by helping reduce overfitting and model complexity. Ridge
regression works in a similar fashion but by enforcing L2 penalties, which does not
produce sparse models.
• Regression Trees Elith et al. (2008): A decision tree is an ML architecture that uses a
flowchart-like structure to arrive to infer a result by taking tests over input variables.
Each node of the tree is a test on an input variable and depending on the outcome,
the flow continues in one branch of the tree or another until the flow reaches the leaves
where final outputs are given. Regression trees are just an extension of decision trees
where the target value to predict takes the form of a continuous value.
• Random Forest Breiman (2001): A classification or regression method that works
by constructing multiple decision trees at training times. That multitude of trees
constitutes an ensemble to produce a final prediction (e.g., in the case of classification
by voting and in the case of regression by averaging the outputs of all trees).
• Support Vector Machines Cortes and Vapnik (1995): Binary classifiers that map the
training samples to points in another space to maximize the gap between the two
categories. They can also perform non-linear classification using specific kernels
which map those inputs to high-dimensional feature spaces where non-linear decision
boundaries can be tackled. Intuitively, an SVM finds a hyperplane that optimally
separates the decision boundary by maximizing the distance between one class and
another. They can also be used for regression with the appropriate modifications
(namely, Support Vector Regressions (SVRs)).
Apart from the classical algorithms, we also briefly explain the modern architectures
that are more popular mainly due to the advent of deep learning:
• Neural Networks (NNs) are the most basic architecture, usually composed of indi-
vidual perceptrons which are arranged into multiple layers—usually with non-linear
Risks 2022, 10, 84 15 of 46

activation functions interleaved—of varying width. A perceptron Rosenblatt (1958) is

a function f that maps an input x to generate an output z in the following way:

z = f ( x ) = σ (wx + b), (15)

where w is a vector of weights, b is a bias, and σ is an activation function.

In its most simple form, the activation function is just a threshold and the perceptron
is just a binary classifier. Note that the bias simply shifts the decision boundary away
from the origin. Single-layer perceptrons can be combined together to form a Multi-
layer Perceptron (MLP). This architecture is usually composed of three layers: the
input layer as before, a hidden layer, and an output one. The input layer remains as
before, but the hidden and output ones can be composed by an arbitrary number of
nodes (also named neurons). Each of those nodes is a single-layer perceptron that
uses a non-linear activation function. Deep Neural Network (NN) (also called fully
connected networks) often refer to MLPs with more hidden layers l. In this general
case, the output of a certain neuron i of a layer l can be defined as follows:

zil = σl (wil ∗ zl −1 + bil ) (16)

Vanilla NNs are capable of learning any non-linear function (they are universal ap-
proximators) given enough network complexity, but they face a number of challenges:
(1) due to their fully connected nature, they require a huge number of parameters,
(2) are usually harder to train, (3) they lose spatial information of the input, and (4)
there is no built-in mechanism for capturing sequential data.
• Convolutional Neural Networks (CNNs) LeCun et al. (1998) uses learnable kernel fil-
ters to extract relevant features from the inputs by applying the convolution operation
with them. They are especially useful with structured data and in those cases where
spatial information is important. Typically, they are currently applied to process 2D
images (although a convolution can be applied to any dimensionality). For instance,
for the 1D case, we can formulate the output of a single neuron in a CNN as follows:

zil = σ ∑ wkl xil−

−1
k, (17)
k

where wkl is a vector of weights, also named the kernel, with k elements. This kernel
is convoluted over the adequate portion of the input xi−k and passed through a non-
linear activation function to compute the output of that neuron. As we can observe,
a CNN shares this kernel across the whole layer and, by doing so, it does not fully
connect each neuron from the previous layer to the next ones. Furthermore, each layer
can have more than one kernel; each one is convoluted individually to produce a
separate output. These outputs are often referred to as feature maps and are stacked
to form a multi-channeled output.
With regards to fully connected NNs, they sport some advantages: (1) as we mentioned,
by convolving the input with filters of predefined size instead of being fully connected,
they capture spatial features, and (2) by not being fully connected, but instead sharing
kernel weights across the whole input, they require way less parameters and thus are
easier to train and less prone to overfitting.
• Recurrent Neural Networks (RNNs) are specifically designed to deal with sequence
data and learn from temporal information. Although internally they can be shaped
either as traditional NNs or CNNs, they usually add recurrent connections in their
layers, which helps take into account the state from previous sequence elements
or temporal instants. They therefore can capture sequential information and share
parameters across different timesteps (in a similar fashion as CNNs do spatially).
Typically, the most general topology is a fully recurrent RNN where the outputs of all
neurons are connected to the inputs of all for them. Each one multiplies the current
inputs and previous outputs through an activation function. Other relevant topologies
Risks 2022, 10, 84 16 of 46

are Gated Recurrent Unit Network (GRU) and the widely spread Long-short Term
Memory (LSTM).
GRUs Cho et al. (2014) features two gating mechanisms: update and reset. The update
gate is responsible for determining the amount of previous information that will flow
to the next step. The reset gate decides which information from the past timestep to
neglect for the current state.
LSTMs Hochreiter and Schmidhuber (1997) features three gating mechanisms: input,
output, and forget. This triple gate system allows the architecture to model long- and
short-term dependencies properly.
As a matter of fact, all vanilla RNNs, GRUs, or LSTMs are able to model arbitrary time
dependencies. The problem is, however, computational and numerical: due to the
nature of the training process, the required gradients to learn can easily explode (turn
to infinity) or vanish (go to zero) preventing any learning. GRUs are a step forward in
comparison with vanilla RNNs and the additional gates from LSTMs help even more
to control the information flow to avoid those problems.

3.2.2. Unsupervised Learning

The dataset D contains samples xi without their expected outputs, such as, a set of
images of dogs, cats, and mouses but without labels whatsoever, so D = { x0 , ..., xn }. In this
case, we do not know how f behaves, and therefore we cannot learn the output mapping
f ( xi ) = yi . Given this setting, the goal of unsupervised learning is to learn a function g
that finds patterns or trends in the dataset. For instance, g could be a function that clusters
samples in D based on their similarity according to certain features.
Here, we describe the most common unsupervised learning methods, which are often
employed as pre-processing steps:
• k-Means Clustering: Usually employed as a pre-processing technique to reduce the
number of data points by summarizing them according to their mean expectations.
In other words, it takes a number of samples (n) and aims to partition them in some
sets (k, where k < n) so that the variance within each cluster is minimized. The most
common algorithm is the iterative or naïve k-means Lloyd (1982).
• Principal Components Analysis (PCA) Pearson (1901): Another common pre-processing
technique to reduce the number of features while preserving their variance. It does
so by computing the principal components of the input data and then using them to
perform a change of basis.
It is important to remark Generative Adversarial Networks (GANs) Creswell et al.
(2018): An architecture in which two networks (generator and discriminator) compete
(adversarial); the goal of the generator is to produce samples able to fool the discriminator
whilst the discriminator’s role is to detect false examples from the generator. In other
words, given a training set, this architecture is able to generate new data that statistically
resembles the originally provided. Although initially proposed as a form of generative
model for Unsupervised Learning, it has now impacted all paradigms.

3.2.3. Reinforcement Learning

The dataset D does not even exist beforehand, but new samples xi arrive or are
generated on the fly, such as, the current state of a chess board in a match after a movement
has been performed. A function g which produces an output zi given a sample and modifies
the current state to produce another sample xi+1 . At any state or at certain times, we can
measure how good this g is behaving according to a predefined criteria. The goal is to learn
a g that will maximize (or minimize) such criteria.
Reinforcement Learning (RL) can be typically subdivided into two main categories
Sutton and Barto (2018): model-based and model-free. The first builds an internal model of
the possible states, transitions, and outcomes in the environment; the latter does not use
any model but rather learns actions/transitions directly from experience at the expense of
statistical efficiency.
Risks 2022, 10, 84 17 of 46

As we will review later, the most common reinforcement learning algorithm for
finance is Q-learning Watkins and Dayan (1992) and its deep counterpart Deep Q-learning
Hester et al. (2018). Q-learning learns a so-called quality or action-value function, which
describes how good is it to take a particular action in a determined state. To do so, a table
of state-action pairs is kept; this table assigns a scalar reward that defines the quality of
the action at a given state. During training, actions are performed either randomly or by
looking at the best one in the table. By analyizing the reward after each action, the state-
action table can be updated based on the old reward values and the new ones. Deep
Q-learning keeps the same procedure, but makes use of deep neural networks to represent
the state-action table; it is typically applied in problems in which the option space is so big
that defining a state-action table would be too complex and computationally expensive.
Another successful trend of RL is Recurrent Reinforcement Learning (RRL) Li et al.
(2015). RRL combines Supervised Learning with Reinforcement Learning typically by
employing a RNN to learn the representation of hidden states for the RL algorithm, which
is normally a deep Q-learning network to obtain the policy that maximizes the reward.

3.3. Performance Criteria

As we will see in Section 5, about Methods, one of the most interesting areas of
analysis has to do with the degree of heterogeneity of the performance criteria measures
used by researchers in the last five years. The utilization of different measures of return
has coexisted with diverse measures of dispersion or volatility and, in some other cases,
with ratios of joint measure of risk adjusted return. This is one of the reasons why the
reproducibility of this type of research might be questioned. In the next lines we will make
a review and description of the main indicators of performance used in the literature of ML
applications to Asset Management: returns, risk/returns ratios, goodness of fit/prediction,
risk of loss measures, statistical significance, and accuracy of predictions.

3.3.1. Returns
Average returns appear as the first type of performance measure. Depending on the
data frequency, we can find daily, monthly and annual returns as measures of profitability
of the different investment strategies the authors propose using ML applications.
• As summary measure of return we can define the annualized rate of return as the
Compounded Annual Growth Rate (CAGR) of the portfolio value between two peri-
ods separated n years:
 (1/n)
Pt+n
CAGR = −1 (18)
Pt
Pt being the investment value in period t and n the number of years between the two
periods we want to compare.
• Sometimes, the returns are measured in terms of Excess Returns. That means that
the portfolio return is measured in terms of comparison with the risk-free asset or,
in general, a benchmark asset that is used as reference. The arithmetic excess return
can be expressed as follows:
R EA = R p − Rb (19)
where R p is the portfolio return and Rb the benchmark return. We can also define the
excess return as a geometric measure:

E Rp + 1
RG = −1 (20)
Rb + 1

3.3.2. Risk/Return Ratios

In many cases, the authors who propose new ML techniques in order to find a better
fitting or prediction capacity in financial strategies have opted by considering the risk
involved in achieving certain returns. Since the 1960s, investors and researchers have
Risks 2022, 10, 84 18 of 46

known how to quantify and measure risk with the variability of returns, basically using
ratios, but no single measure actually looked at both risk and return together.
• The most popular ratio to measure portfolio performance is the Sharpe Ratio (SR).
Conceived by Bill Sharpe, this measure closely follows his work on the CAPM and,
by extension, uses total risk to compare portfolios to the Capital Market Line (CML).
It compares the portfolio return with the risk involved in achieving this return, in form
of total risk, measured through the return standard deviation, as follows:

R p − Rb
SR = (21)
σp

σp being the standard deviation of portfolio returns.

• Differential Return (DR), by contrast, results in an excess return for the portfolio
manager that considers risk in the form of standard deviation (the variability of past
returns). It is a sort of a modified Sharpe ratio. Here is the formula:

Rb − RFR
 
DR = R p − ∗ σp − RFR (22)
σRb

where RFR is the risk-free rate of return.

• When we used the systematic risk measured by the CAPM, instead of total risk, we are
referring to Treynor Ratio (TR):

R p − Rb
TR = (23)
βp

where β p is the covariance between portfolio returns and market returns according
to CAPM.
• We can find another very popular ratio, the Calmar Ratio (CR), which can be defined as
the ratio between the CAGR and its Maximum Drawdown (MDD) which, at the same
time, measures the maximum observed loss from a peak to a trough of a portfolio,
before a new peak is attained, and can be considered as an indicator of a downside
risk over a specified time period.

CAGR
CR = (24)
MDD
A very similar approach is achieved by the Sterling Ratio (STR).
• Finally, the Certainty Equivalent Return (CEQ) considers the risk-free return for an
investor with quadratic utility and risk aversion parameter λ compared to the risky
portfolio and is given by the following equation:

λ 2
CEQ = (µ − RFR) − σ (25)
2

3.3.3. Goodness of Fit/Prediction

A statistical model’s goodness of fit defines how well it fits a collection of data. The
disparity between actual values and predicted values under the model in issue is often
summarized by goodness of fit measures. Very similarly, goodness of prediction refers
to discrepancy between observed values and the values predicted by the model. Every
goodness of fit statistic can be defined/used for prediction purposes, and vice versa.
• For linear regression models, R-squared is a goodness-of-fit metric. This statistic
shows the percentage of variance in the dependent variable that the independent
factors account for when taken jointly. The strength of the link between your model
Risks 2022, 10, 84 19 of 46

and the dependent variable is measured by R-squared, which is defined between 0

and 1. It can be calculated as follows:

∑i (yi − ŷi )2
R2 = 1 − (26)
∑i (yi − ȳ)2

where yi is the actual i-observation of dependent variable y, ŷi its estimated value,
and ȳ its mean value. When the estimated values are substituted by the predicted ones,
we are talking about Out-of-the-Sample R Squared (OOS R2), a measure of goodness
of prediction.
• Mean Absolute Percentage Error (MAPE) is one of the most commonly used perfor-
mance indicators to measure forecast accuracy. It can be defined as the sum of the
individual absolute errors divided by the observed value (each period separately).
It is the average of the percentage errors.
n
1 yi − ŷi
MAPE =
n ∑ yi
(27)
i =1

where n is the number of forecast periods. It is a quite well-known indicator among

researchers, despite being a poor accuracy indicator. As it can be seen in the formula,
MAPE divides each error individually by the observed value, so it is skewed.
• Mean Absolute Error (MAE) is a very useful performance indicator to measure forecast
accuracy. As the name implies, it is the mean of the absolute error.
n
1
MAE =
n ∑ |yi − ŷi | (28)
i =1

It solves the problem of skewness of the previous indicator but, in return, it is not
scaled, so it depends on the magnitude of the dependent variable.
• Root Mean Squared Error (RMSE) is a frequently used measure of the differences
between values (sample or population values) predicted by a model or an estimator
and the values observed.
s
1 n
n i∑
RMSE = (yi − ŷi )2 (29)
=1

The RMSE serves to aggregate the magnitudes of the errors in predictions for various
data points into a single measure of predictive power. RMSE is a measure of accuracy,
to compare forecasting errors of different models for a particular dataset and not
between datasets, as it is scale-dependent. Actually, many algorithms (especially for
ML) are based on the Mean Squared Error (MSE), which is directly related to RMSE.
n
1
MSE =
n ∑ (yi − ŷi )2 (30)
i =1

3.3.4. Risk of Loss Measures

Risk of loss measures are typically used by firms and regulators in the financial
industry to gauge the amount of assets needed to cover possible losses. But they are also
very common in financial research to compare the risk associated with market and credit
positions, mainly in the Risk Management discipline.
• Value at Risk (VaR) is a metric for calculating investment risk. It calculates how much
a set of assets would lose (with a specified probability) in a specific time period, such
as a day, under typical market conditions. According to Abad et al. (2014), the VaR
is thus a conditional quantile of the asset return loss distribution. Let r1 , r2 , r3 , ..., rn
be identically distributed independent random variables representing the financial
Risks 2022, 10, 84 20 of 46

returns. Use F (r ) to denote the cumulative distribution function, F (r ) = Pr (rt < r |

Ωt−1 ) conditionally on the information set Ωt−1 that is available at time t − 1. Assume
that rt follows the stochastic process:

r t = µ + et
et = zt σt zt ∼ iid(0, 1) (31)

where σt2 = E(z2t | Ωt−1 ) and zt has the conditional distribution function G (z),
G (z) = Pr (zt < z | Ωt−1 ). The VaR with a given probability α ∈ (0, 1), denoted by
VaR(α), is defined as the α quantile of the probability distribution of financial returns:

F (VaR(α)) = Pr (rt < VaR(α)) = α or

VaR(α) = in f (v | Pr (rt ≤ v) = α) (32)

This quantile can be estimated in two different ways: (1) inverting the distribution
function of financial returns, F (r ) and (2) inverting the distribution function of inno-
vations G (z), in which case is also necessary to estimate σt2 .

VaR(α) = F −1 (α) = µ + σt G −1 (α) (33)

• Conditional Value at Risk (CVaR), also known as Expected Shortfall (ES), is a risk
measure derived from the previous one. The ES at the α% level is the expected return
on the portfolio in the worst α% of cases. ES is an alternative to VaR that is more
sensitive to the shape of the tail of the loss distribution.
The estimation of risk measures has recently gained a lot of attention, partly because
of the backtesting issues of VaR and CVaR related to elicitability. As Pitera and Schmidt
(2018) mention, “once the parameters of a model need to be estimated, one has to take
additional care when estimating risks”. The typical estimations approaches, very often,
introduce a bias which leads to a systematic underestimation of risk.

3.3.5. Statistical Significance

Many times, researchers are interested in checking whether the variables, factors or
characteristics included in the models they propose are statistically significant. In order to
achieve this result, they make the usual statistical hypothesis tests based in the t-student
distribution. According to this, t-student statistic and p-value are the two most common
measures to check the statistical significance.
A result has statistical significance in hypothesis testing when it is extremely improba-
ble to have occurred given the null hypothesis. The significance level of the study rejecting
the null hypothesis, represented by α, is the probability of the study rejecting the null
hypothesis if this is true.
• Most times, hypothesis testing of statistical significance can be run using a t-student
distribution. The t-statistic can be expressed this way:

X−µ
t= √ (34)
σ̂/ n

where X is the sample mean from a sample x1 , x2 , . . . , xn , of size n, σ̂ is the estimate of

the standard deviation of the population, and µ is the population mean. When the
t-statistic value is higher, in absolute value, than the critical value of the t-student
distribution given a significance level α, the null hypothesis can be rejected, and it can
be affirmed than the coefficient or loading is statistically significant, and the variable,
factor or characteristic can be considered as relevant.
Risks 2022, 10, 84 21 of 46

• The p-value in hypothesis significance testing is the probability of getting test findings
that are at least as extreme as the actual results, assuming that the null hypothesis
is valid. A tiny p-value indicates that under the null hypothesis, such an extreme
observed result would be very implausible. p-values of statistical tests are commonly
reported in academic articles in a variety of quantitative domains.

p-value = Pr ( T ≥ t| H0 ) (35)

for a one-sided left-tail test, being H0 the null hypothesis. In a formal significance test,
the null hypothesis H0 is rejected if the p-value is less than a predefined threshold
value α, which is referred to as the significance level. The meaning is equivalent
to that in which the t-student statistic is higher than the critical value at a given
significance level.

3.3.6. Accuracy of Predictions

In the case of price forecasting and algorithmic trading techniques, performance of the
selected classifiers is evaluated using different evaluation metrics. Since the problem is a
multi-class classification problem and the distribution of classes is not uniform, therefore it
is very common to use accuracy primary classification metrics, namely, precision, recall,
and the F-measure.
• Accuracy is a classification metric for evaluating classifiers and can be expressed as:

# correct predictions
Accuracy = (36)
Total # predictions

• Precision is the skill of the model to classify samples accurately and can be calculated
as follows:
TP
Precision = (37)
TP + FP
where TP is the true-positive rate and FP is the false-positive rate of the algorithm.
• Recall shows the skill of the model to classify the maximum possible samples, and is
represented by the following equation:

TP
Recall = (38)
TP + FN
where FN is the false-negative rate of the algorithm.
• F-measure describes both precision and recall and can be represented as follows:

Precision · Recall
F-measure = 2 · (39)
Precision + Recall

4. Datasets
According to Arnott et al. (2019), one crucial limitation of ML applications in Finance
involves data availability. On the one hand, it has been hard to find standardized data
sources for finance. On the other hand, deep ML methods usually require large datasets
where complex patterns can be extracted while avoiding overfitting LeCun et al. (2015);
those kind of datasets are hard to generate in finance. Therefore, data plays a key role in
any ML application to asset management.
The work on asset management papers related to ML techniques may be categorized
based on the kind of inputs used. A significant number of the articles examined employ
structured type inputs, for which processing techniques already exist and the relevance
of which has been thoroughly researched. The more current ones permit the usage of
unstructured data, which is more difficult to analyse and extract valuable data from. In this
section, we review both sources of data.
Risks 2022, 10, 84 22 of 46

4.1. Structured Data

When we talk about structured data we are referring to data which is organized and
fits tidily into spreadsheets and relational databases. This kind of data is quantitative
and is often displayed as numbers, dates, values, and strings. It is usually stored in rows
and columns.
Most of the articles revised in this work use this type of structure in their information,
which is usually open and prepared for API programming interfaces. The most common
is the time-series of historical prices, with different frequencies. The preferred periodicity
is monthly, but in other cases we can find yearly or daily data. In the case of algorithmic
trading, some High Frequency Trading (HFT) models use intraday data.

4.1.1. Stock Values

Generally, this information is public and free and can be downloaded from the pages
of the stock markets. Besides, some companies like Bloomberg and Reuters provide
paid services with additional information related to stock prices. In some articles, daily
stock information is used, which consists of opening price, closing price, maximum and
minimum, as well as the volume of transactions or negotiation. In the case of intraday
information, it is very usual to find data related to bid-ask spread.

4.1.2. Macroeconomic Indicators and Financial Information

Taking into account that a large list of papers are focused on asset pricing and factor
investing, it is very usual to use corporate information from financial reports to estimate
the fair value of the stock. These financial reports are the balance sheet, the income
statement and the cash flow statement. Related to them, we can find calculated indicators
called financial ratios, which summarize the company’s financial and economic situation
numerically. Some of these ratios are Debt to Equity, Price to Earnings or Enterprise Value to
Operating Earnings (EBITDA). This information is usually provided by private companies
like Bloomberg or Thompson Reuters.
Many times, fundamental analysis uses macroeconomic indicators to understand
how the stock prices are correlated to changes in variables outside the company. Firstly,
because depending on the health of a country’s economy, one can estimate the earnings
growth of a company, and secondly, because the consumption is on the basis of the majority
of asset pricing models. These economic indicators are usually free and published by
governments and public institutions. However, they have an important pitfall: their low
frequency and the relevant lag with regard to the current prices.

4.1.3. Technical Indicators

This category of data is very focused on algorithmic trading, since they are useful for
predicting the stock market direction. Technical indicators are not based on economic or fi-
nancial models. Traders that utilize technical analysis use heuristic or pattern-based signals
generated by the price, volume, and/or open interest of a security or contract. Technical
analysts utilize indicators to forecast future price changes by evaluating previous data.
There are two types of technical indicators: trend indicators and oscillators. The former
ones are focused on identifying movement directions, and the latter ones on finding the
turning points in the time-series.
All of then can be calculated using the information of prices obtained in the first
section, or directly downloaded from the same information sources. Bloomberg is the main
source for this type of data.

4.2. Unstructured Data

Unstructured data, unlike structured ones, have no predefined construction or system-
atization. It comes in text form, audio, images, videos and can be challenging to analyze.
The utilization of unstructured data increases the complexity of stock market fore-
casting, but at the same time opens a whole new world of possibilities. In order to be
Risks 2022, 10, 84 23 of 46

utilized as an input for the model, this data must be preprocessed and transformed to
categorical or numerical data. Text mining algorithms, which extract news segments or
views from social networks and may create numerical representations, are required for
textual unstructured inputs.
The news analysis is usually taken from media sources, but sometimes from the same
company. In the case of social networks, we are talking about a very new, challenging and
complex world. In this case, the main problem is the enormous volume of information as
well as the computational challenges.
News feeds, social media, earnings call transcripts, multiple CRM platforms, email,
call notes, and other unstructured data sources are common in Finance. The attractive-
ness and added value come from a substantially better information base, which includes
unstructured data for decision-making that is both relevant and timely.

4.3. Analysis
In order to get a more complete perspective about the type of datasets which are
used in the research about ML applied to Finance, we will select a small sample of articles
within the three areas of research we have used in previous sections. To obtain this sample,
we will apply a double filter: firstly, to be published in a Q1–Q2 journal, and, secondly,
to be classified in the first quartile in terms of number of citations.

4.3.1. Value/Factor Investing

In this particular field of financial research, it is very common to use public and shared
datasets, many times constructed, updated and fed by the own authors. The most usual
data frequency is monthly.
• Kozak et al. (2018). The methodology used is a very good example of how this type
of datasets can be a good way to generate results that can be globally interpreted.
In this work, the authors use, firstly, the 5 × 5 size and book-to-market (B/M) sorted
portfolios of Fama and French (1993). Secondly, they use 15 anomaly long-short
strategies defined as in Novy-Marx and Velikov (2016) and the underlying 30 portfolios
from the long and short sides of these strategies. These two datasets are available
in two websites fed by the own authors, with the aim to contribute to future and
reproducible research. In the first case, datasets are provided by the Kenneth French’s
website, which provides downloadable and updated files of Fama/French factors
from 1926. In the second case, the author shares the datasets used in his 2016 article.
The French’s webpage can be considered as one of the best examples of publicly
available databases that has become as meeting point of asset pricing researchers.
• Feng et al. (2020). In this paper we can find another excellent example of how using
publicly available datasets from other authors. In their article, the authors firstly
download all workhorse factors in the U.S. equity market from Ken French’s data
library. Then they add several published factors directly from the authors’ websites,
including liquidity from Pastor and Stambaugh (2003) (Stambaugh’s website), the q-
factors from Hou and Zhang (2015), and the intermediary asset pricing factors from
He et al. (2016). In addition to these 15 publicly available factors, they follow Fama and
French (1993) to construct 135 long-short value-weighted portfolios as factor proxies,
using firm characteristics surveyed in Hou et al. (2017) and Green et al. (2016).
• Gu et al. (2021). Another example of academic database, but in this case accessible
by subscription, is Center for Research in Security Prices (CRSP) US Stock Databases,
an affiliate of University of Chicago, which contain daily and monthly market and
corporate action data for over 32,000 active and inactive securities with primary
listings on the NYSE, NYSE American and NASDAQ. The research-quality data
created by this transformational project spawned a vast amount of scholarly research
from several generations of academics. Today, nearly 500 leading academic institutions
in 35 countries rely on CRSP data for academic research and to support classroom
Risks 2022, 10, 84 24 of 46

instructions. The CRSP value-weighted index is one of the most usual equity market
benchmarks used in financial research.

4.3.2. Portfolio Management

After analyzing the most cited papers within this discipline, we can conclude that,
in most of cases, the datasets are composed exclusively by price data. Just in some cases
financial data or news can be found in the articles researched. Sometimes, the closing price
is joined by other indicators of prices, as maximum, minimum or opening price. Most
times, the assets utilized are stock indices constituents and, eventually, Exchange Traded
Fund (ETF) prices. The data sources are Datastream, Bloomberg and, in some specific cases,
Ken French’s website.
• Heaton et al. (2017). Weekly returns data for the components of the biotechnology IBB
index in the period 2012–2016. They train the learner without knowledge of the actual
component weights. Their goal is to find a selection of investments that outperforms
the official index.
• Krauss et al. (2017). Monthly and daily returns data for the components of S&P
500 in the period 1989–2015. The data source is the Thomson Reuters Datastream.
The goal was to build portfolios following a statistical arbitrage strategy with better
performance than the benchmark index.
• Ban et al. (2018). Ken French’s website mentioned in the section of asset pricing. They
collect monthly excess returns for three different data sets, composed of 5, 10 and
49 industry portfolios, in the period 1994–2013.
• Almahdi and Yang (2017). A five-asset portfolio using five of the most commonly
traded ETFs from different asset categories. They extract the weekly closing prices for
each of the five assets from Yahoo Finance website, for the period 2011–2015.
• Lee et al. (2019). Data over a period of 22 years from 1995 to 2016, sourced from
Thomson Reuters Datastream database. The dataset is composed by weekly closing
prices of 10 global equity indices.
• Paiva et al. (2019). Opening, closing, maximum and minimum daily prices of the
components of the Brazilian index Ibovespa, from 2001 to 2016. They were sourced
from the Bloomberg terminal.

4.3.3. Price Forecasting

In this third discipline, the datasets used in the most cited articles are quite diverse,
depending on the methodology implemented.
• Nikou et al. (2019). In some cases, historical closing prices are the only reference,
where the data used include the daily closing price of iShares MSCI UK ETF, also
collected from the Yahoo Finance site.
• Zhong and Enke (2019). In other cases we can find financial and economic factors
-as in asset pricing models-. In this paper, the dataset includes the daily direction
(up or down) of the closing price of the SPDR S&P 500 ETF as the output, along
with 60 financial and economic factors as input features. The daily data is collected
from 2518 trading days from June 2003. The data sources are public and free (e.g.,
finance.yahoo.com).
• Khan et al. (2020). Lastly, we can find some examples of financial news and social
media data, perfect examples of unstructured data. The source of stock historical
daily prices is the same, Yahoo Finance, but the downloaded data have seven features,
from date to closing price, passing by traded volume. Given the methodology used in
the article, financial news data are also needed, as well as social media data. In the first
case, the authors have used Business Insider because it contains a collection of stock
market related news from the most famous world news websites, such as Reuters,
Financial Times, and so forth. In the second case, they have utilized Twitter API,
implemented in Python, to download desired tweets.
Risks 2022, 10, 84 25 of 46

5. Methods
In this section, we will make an extensive review of all the literature regarding the use
of ML techniques in Asset Management. In this sense, we will try to answer the following
research questions:
• What financial application areas, within the asset management discipline, are of
interest to the financial and ML community?
• In each of these application areas, which ML models/methods are preferred (and
more successful)?
• Which are the most used performance metrics by the researchers?

5.1. Methodology
The revision of literature has been made classifying the papers according to four
financial areas. The three first areas are the financial disciplines we have used in previ-
ous sections: asset pricing/value investing, price forecasting and portfolio management.
The fourth one, algorithmic trading, might be classified, from a conceptual point of view,
as an intermediate discipline between portfolio management—since it can be considered as
an special type of trading strategy and price forecasting—as this trading strategy has as
priority goal to forecast the future direction of prices. Nevertheless, the growing relevance
of this new discipline, not only at a practitioner level, but also between the researchers, has
driven to consider it as an independent area. Given its special characteristics, as we will
expose in Section 5.5, this application field can be considered as one of the most promising
financial areas to be supported by ML applications.
To identify relevant journal articles dealing with ML applications in the four Asset
Management disciplines mentioned above, we followed a search process in EBSCOhost,
Google Scholar, Science Direct, SpringerLink and Wiley Online Library databases for
the period of 2015–2021 using combinations of keywords “machine learning”, “deep
learning”, “neural networks” and “asset management”, “portfolio management”, “asset
pricing”, “asset returns”, “stocks”, “finance”, “price forecasting”, and “algorithmic trading”.
After searching through the databases, we reached a list of around 130 identified papers.
After this first preselection, each paper was assessed on quality. This was achieved
by using a variety of quality indicators as the citation count and the impact factor of the
journal. The arXiv and SSRN databases were also searched to ensure that the most up-to-
date research papers were included in the sample. After this second filter we reached a list
of 91 identified journals (see Table 2). Finally, and after the assessment of each one of the
articles, we focused our research and commentaries in a final number of 60 articles, also
summarized in the different tables throughout the article.

Table 2. Recurring themes and reference count from the literature review.

Themes References
Value Investing 18
Portfolio Management 31
Price Forecasting 25
Algorithmic Trading 17
TOTAL 91

5.2. Value/Factor Investing

This financial area is very wide and can be considered as the starting point for the rest
of interest areas within the Asset Management discipline. We will consider in this section
papers and works regarding the search and location of factors, characteristics, patterns in
securities prices which allow the investor to understand the drivers of asset prices, the way
the expected returns compensate the assumption of risks, and how to outperform the mar-
ket. The selection has been summarized in Table 3. The logic behind value/factor investing,
Risks 2022, 10, 84 26 of 46

in general, is that a firm’s financial performance is influenced by fundamentals/factors,

whether latent and unobservable or connected to fundamental characteristics.
Despite being a decades-old academic topic, value/factor investing has gained pop-
ularity in line with the emergence of equity traded funds (ETFs) as investment vectors,
as we discussed in Section 3.1.1. In the decade of 2010, both gained traction. The mutually
advantageous feedback loop between practical financial engineering and academic research
has encouraged both sides, which is not surprising.
Nevertheless, in the realm of traditional quantitative techniques, researchers have
developed in recent years more sophisticated approaches to organize the so-called “factor
zoo” and, more crucially, to detect false anomalies and evaluate alternative asset pricing
model specifications due to the ever-increasing number of factors and their relevance in
asset management. Hundreds of possible candidates have emerged from the search for
factors that explain the cross-section of expected stock returns, as noted by Cochrane (2011)
and more recently by Harvey and Liu (2019), David McLean and Pontiff (2016), and Hou
et al. (2017).
For instance, Harvey and Liu (2019) used bootstrap on orthogonalized factors in
their regressions to solve the problem of correlations among predictors. Fama and French
(2018) compared asset pricing models through squared maximum Sharpe ratios, and Giglio
and Xiu (2019) estimated factor risk premia using a three-pass method based on principal
component analysis. It is obvious that there does not exist an infallible method, but the
majority of new contributions in the field are interested in the search for robustness.
In all the previous cases, the decomposition of returns has been made using linear
factor models, of course because of its simple interpretation. Nevertheless, beyond the
problem of robustness of the estimations, there has been an eternal debate about whether
firms returns are explained by their exposure to macroeconomic factors or simply by their
intrinsic characteristics. Characteristics, rather than factor loadings, explain a higher share
of variation in predicted returns, according to Chordia et al. (2019). On the other hand,
adopting a theoretical model in which certain agents’ needs are sentiment-driven, Kozak
et al. (2018) reconciles factor-based theories of risk premia.
In all this immense sea of different approaches to the factor investing discipline,
and given the exponential increase in data availability, ML techniques make their appear-
ance with the aim to help avoid the mentioned limitations of classical approaches. As we
mentioned in Section 3, the work from Gu et al. (2020) provided a detailed description
of ML tools for empirical asset pricing and give their justification for the growing role of
ML in financial research. They perform a comparative analysis of ML methods for “the
canonical problem of empirical asset pricing: measuring asset risk premiums”. The meth-
ods they compare are, between others, generalized linear models, dimension reduction
tools, Boosted Regression Trees (BRTs), and Random Forests (RFs). In comparison with
standard forecasting approaches, they discover that ML tools increase the description of
predicted returns. They also highlight that all ML techniques agree on a limited set of
main predictive signals, which include variants on momentum, liquidity, and volatility,
and that BRT and NN are the top performing techniques. According to the authors, these
findings suggest that enhanced risk premium measurement by ML can simplify the exami-
nation of asset pricing economic mechanisms, and that ML is a viable technique for new
financial technology.
Risks 2022, 10, 84 27 of 46

Table 3. Selection of papers for value/factor investing. Mean Absolute Percentage Error (MAPE),
Out-of-the-Sample (OOS), Mean Standard Error (MSE), and Maximum Drawdown (MDD).

Performance
Author Target Market Method
Criteria
Average return,
NYSE, Amex and
Tobek and Hronec (2020) WLS, PWLS, RF, GBRT, NN Sharpe ratio,
NASDAQ common stocks
MDD
US stocks, T-bonds, R Squared,
Giglio and Xiu (2019) PCA
C-Bonds and currencies p-value
R Squared,
Kelly et al. (2018) World stocks IPCA
p-value
Excess returns,
Moritz and Zimmermann (2016) US stocks DT
R Squared, MSE
Bayesian and Lasso OOS R2, Sharpe
Kozak et al. (2019) US stocks
Regressions ratio
Messmer (2017) US stocks DFNN Sharpe ratio
NYSE, Amex and
Feng et al. (2018a) DFNN Sharpe ratio
NASDAQ common stocks
Chen et al. (2020) US stocks DFNN, LSTM, GAN Sharpe ratio

NYSE, Amex and

Feng et al. (2018b) TensorFlow, SGD, AD MSE, R Squared
NASDAQ common stocks
R Squared,
Simonian et al. (2019) US stocks RF, ARL Annual return,
Sharpe ratio
SR, Mean
Sun (2020) NYSE common stocks Ordered-Weighted LASSO
returns
NYSE, Amex and
Freyberger et al. (2020) LASSO Sharpe ratio
NASDAQ common stocks
Average return,
Lu et al. (2019) Chinese stocks NN, MLP
Sharpe ratio
Feng and He (2019) US stocks Bayesian Hierarchical OOS R2
SR, Mean
Feng et al. (2020) US stocks DS LASSO
returns, t-stat
Average return,
Sugitomo and Minami (2018) TOPIX 500 stocks SVM, GBRT and NN Sharpe ratio,
RMSE
Average return,
Avramov et al. (2021) US stocks NN3, FFN, LSTM, GAN
Sharpe ratio
Average return,
Aw et al. (2019) US stocks NNs
Sharpe ratio
NYSE, Amex and R Squared,
Gogas et al. (2018) SVR
NASDAQ common stocks MAPE

The review of specific papers about application of ML techniques to Asset Pricing

could start with the contribution mentioned above of Giglio and Xiu (2019). The authors
use PCA to solve the problem of bias in the estimation of linear asset pricing models when
some priced factors are omitted. They show that in a linear factor model, the risk premium
of a factor may be identified independently of the rotation of the other control factors as
long as they all cover the actual factor space.
In a similar way, Kelly et al. (2018) presented the Instrumented PCA, a new cross-
sectional modeling technique for equity returns that accounts for latent factors and time-
varying loadings by incorporating observable features that instrument for the unobservable
dynamic loadings. In this sense, if IPCA tool identifies the corresponding latent factors,
that will mean that the relationship between characteristics and expected returns is due to
risk compensation. The other way round, if no such factors exist, the characteristic effect
will be compensation without risk or “anomaly”.
The closest work in methodology and application of ML techniques to Gu et al. (2020)
comes from Tobek and Hronec (2020). The authors look at out-of-sample returns on over
a hundred equities anomalies that have been recorded in scholarly literature. They then
demonstrate that ML approaches that combine all anomalies into a single mispricing
signal are valuable all around the world and can persist in a liquid universe of stocks.
Risks 2022, 10, 84 28 of 46

Among others, the techniques used are Weighted Least Squares (WLS), Penalized Weighted
Least Squares (PWLS), RFs, Gradient Boosted Regression Trees (GBRTs) and NNs.
Moritz and Zimmermann (2016) also used an ML approach to look at the cross-section
of stock returns. In the context of portfolio sorting, they utilize tree-based models to link
information from previous returns to future returns. The authors demonstrate that the
traditional linear Fama–MacBeth framework does not take use of all of the data’s significant
information, and that their ML approach is more robust.
There are two aforementioned contributions which deserve additional analysis. In
Kozak et al. (2018), the authors contribute with their study to the everlasting fight between
factors and characteristics, on the one hand, and risk and behavioural explanations to
mispricing, on the other hand. They point out that traditional factor models’ efforts to
summarize the cross-section of stock returns using a sparse number of characteristic-based
factors was futile. Moreover, there is just not enough redundancy across the large variety
of potential predictors for such a basic model to price the cross-section appropriately. As a
result, a SDF model requires a large number of characteristic-based factors to be loaded. ML
techniques, and more specifically, the unsupervised statistical technique PCA, helps in this
process, which might be useful in future study on the economic interpretation of the SDF.
In Kozak et al. (2019), the authors’ method achieves robust out-of-sample performance by
imposing an economically motivated prior on SDF coefficients that shrinks contributions of
low-variance principal components of the candidate characteristics-based factors. In other
words, if the characteristic-based models doesn’t work well with a very low number of
factors, a SDF formed from a small number of principal components performs well.
Without a doubt, the most frequent technique of ML in the literature are NNs. A first
example of this kind of approach can be found in Messmer (2017). Based on a very large
set of firm characteristics, they use DL techniques to predict the US cross-section of stock
returns. Specifically, they train a deep NN and, after applying a network optimization
strategy, he finds that deep NN learned long-short portfolios can generate attractive risk-
adjusted returns in comparison with a linear model. This result highlights the relevance
of non-linearities in the relationship between firm characteristics and expected returns.
In the same line of study using DL techniques, Feng et al. (2018b) designed a deep NN
with the aim to minimize pricing errors. As inputs they use firm characteristics, they
generate risk factors as intermediate features, and finally fit the cross-sectional returns
as outputs. Another example of deep NN can be found in Chen et al. (2020), where
the authors combine three different deep neural network structures in a novel way: a
NN to capture non-linearities, a recurrent LSTM network to find a small set of economic
state processes, and a GAN to identify the portfolio strategies with the most unexplained
pricing information estimate. The primary contributions of this study include the use of
the fundamental non-arbitrage condition as a criteria function, the use of an adversarial
technique to design the most informative test assets, and the extraction of economic states
from a large number of macroeconomic time-series.
The procedure of sorting securities, based on firm characteristics, very usual in factor
investing literature, is the starting point of the work by Feng et al. (2018a), which uses
multi-layer deep networks to augment traditional long-short factor models.
Another notable architectures are RFs, which are one of the most used classical tech-
niques of ML in recent years. For instance, Simonian et al. (2019) showed how to use RFs
to produce factor frameworks that improve upon more traditional models in terms of their
ability to account for non-linearities and interaction effects among variables, as well as their
higher explanatory power. In combination with Association Rule Learning (ARL), they are
able to produce viable trading strategies.
Sun (2020) proposed a new ML method, the Ordered and Weighted LASSO (OWL),
which circumvents complications from correlations between the different factors in the
traditional approach. This method can identify and group correlated factors while shrinking
off redundant ones. Using Monte Carlo simulations, he shows that OWL outperforms
Risks 2022, 10, 84 29 of 46

Least Absolute Shrinkage and Selection Operator (LASSO), specially when factors are
highly correlated.
Very similarly, Freyberger et al. (2020) suggested a non-parametric approach for
determining which features give incremental information for the cross-section of ex-
pected returns. They select features and evaluate how they impact expected returns
non-parametrically using the adaptive group LASSO. This technique can manage a high
number of factors, has a flexible form, and is not affected by outliers.
Lu et al. (2019) tried to extract factors according to the definition from Barra team from
MSCI company. They utilize Smart Beta Index technique to construct factor indexes to
reflect performance and style on the market they analyze, and they bring NNs into the
work of cross-section factor integration. Doing so, their experimental results show that the
index that compiled based on factors integration by NNs, specifically with MLP, exhibits
better profitability and stability.
In Feng and He (2019), we can find a Bayesian Hierarchical (BH) approach. This
market-timing method uses heterogeneous time-varying coefficients driven by lagging
fundamental factors to jointly estimate conditional expected returns and residual covariance
matrix, allowing for estimation risk in portfolio analysis. The BH approach also allows
to model different assets separately while sharing information across assets. According
to the authors’ conclusions, the BH approach outperforms alternative methods in terms
of prediction for the US market. At the same time, they were able to identify the most
important factors in the past decade: size, investment and short-term reversal.
The authors of Feng et al. (2020) offered a selection methodology to systematically
assess each new factor’s contribution to asset pricing beyond what a high-dimensional
collection of current factors explains. To evaluate the contribution of a component to
explaining asset prices in a high-dimensional context, they offer combined cross-sectional
asset pricing regressions with the double-selection LASSO of Belloni et al. (2014). This
model selection phase closely resembles the existing literature’s strategy to dealing with
the proliferation of asset price factors (e.g., Kozak et al. (2018)): to take a large set of factors,
to apply some dimension-reduction method (LASSO, Elastic Net (EN), PCA, etc.), and to
interpret the resulting low-dimensional model as the SDF.
Sugitomo and Minami (2018) used a multi-factor model of Fama–French type as
a starting point to test if the ML techniques are able to enhance portfolio performance.
Specifically, they used a typical method, consisting of SVM, GBRT and NN, and verified the
effectiveness and applicability of nonlinear methods in practical operation by comparing it
with conventional linear models.
Avramov et al. (2021) investigated if ML techniques can remove acceptable economic
constraints in empirical finance, which is a largely uncharted field. They investigated
whether signals generated by ML procedures can withstand economic constraints both
in the cross-section and the time-series. For instance, in the cross-section, they remove
microcaps and distressed forms, and in the time-series, they look at the sensitivity of
investment payoffs to market conditions with less arbitrage opportunities. They concentrate
on two DL approaches that perform well with financial data in order to do this job. They
first implement NNs with three hidden layers, and then, they incorporate non-arbitrage
conditions into multiple connected NNs, including vanilla NNs, LSTMs, and GANs.
A ML factor model using NNs is developed by Aw et al. (2019). This model delivers
a superior in-sample performance, but a mediocre out-of-sample performance versus a
conventional factor model. The reason they point out for this underperformance is that the
market noise during the training period overwhelmed the non-linear association uncovered
in the ML process. Nevertheless, they defend that the rationality behind investor behaviour
explains the ultimate success of new ML techniques in asset management.
In Gogas et al. (2018), the methodological approach used is SVR, a direct extension of
SVM and the objective, to evaluate the effectiveness of four of the most popular models
in asset pricing theory, the CAPM, the APT and the three- and five-factor models from
Fama and French. They observe large improvements in comparison to the traditional
Risks 2022, 10, 84 30 of 46

linear regression in terms of the main measures of goodness of fit: R-squared-adjusted

and MAPE.

5.3. Portfolio Management

Portfolio management is the practice of selecting assets for a portfolio during a speci-
fied length of time. Even though the basic purpose is the same, there are somewhat several
variations of this problem, as seen in other financial applications. Portfolio Management is
a broad term that encompasses the following closely related topics: portfolio optimization,
selection, construction and allocation.
In portfolio management, the concept of diversification is extremely relevant, as we can
find in Markowitz (1952). Additionally, very related to diversification, we find the concept
of assets correlation. Goetzmann and Kumar (2008) argues that while investors are aware
of the benefits of diversity, they build portfolios without properly taking the correlations
into account. This is the fundamental reason why, while recent and sophisticated portfolio
optimization approaches perform well in-sample, they typically perform poorly out-of-
sample. For instance, DeMiguel et al. (2009) proves that equal-weighted allocation, which
assigns equal weight to each asset, outperforms the whole range of frequently used portfolio
optimization strategies. In the end, every optimization model requires the inversion of a
positive-definite covariance matrix, which results in errors of such size that the benefits
of diversification are completely neutralized. At this point, ML has an important role to
play with regard to the simplification of the problem. The selection of papers on ML for
portfolio management has been summarized in Table 4.
Ban et al. (2018) adapted two ML methods with regularization for portfolio opti-
mization. The objective of this technique, known with the acronym Performance-based
Regularization (PBR), is to restrict the sample variances of the estimated portfolio risk and
return, guiding the solution towards one with less estimation error in the performance.
The results show how this technique outperforms all other benchmarks in a proportion of
two out of three using Fama–French datasets.
Rasekhschaffe and Jones (2019) explains some of the fundamental ideas behind ML
and offer a simple example of how investors may use ML approaches to estimate cross-
section stock returns while avoiding overfitting. Moreover, in order to demonstrate the
benefits of ML techniques to make accurate forecasts, they emphasize the importance of
mixing forecasts from several algorithms and training periods for diversification. GBRT,
SVM, Adaptive Boosting (AB), Deep Neural Network (DNN) are some examples of the
algorithms used. They demonstrate that, with sensible feature engineering and forecast
combinations, ML algorithms can produce results that dramatically exceed those derived
from simple linear techniques, such as Ordinary Least Squares (OLS).
Very similarly, Huck (2019) presents a summary of the main techniques that can
be implemented to manage a long-short portfolio. He uses three different types of ML
tools: DBNs, RF y EN regression, because they are all able to perform classification tasks
as demanded by the trading system he designs. After developing several independent
statistical arbitrage strategies based on these three ML methods, the article describes
how adding predictors is not a guarantee to increase the performance of the portfolios.
Among the tools considered, the RF seems to generate the best performance portfolios.
Risks 2022, 10, 84 31 of 46

Table 4. Selection of papers for portfolio management. Value at Risk (VaR), Conditional Value at
Risk (CVaR), Maximum Drawdown (MDD), Certainty Equivalent Return (CEQ), Mean Absolute
Percentage Error (MAPE), Mean Absolute Error (MAE), Out-of-the-Sample (OOS), Mean Standard
Error (MSE), Maximum Drawdown (MDD).

Performance
Author Target Market Method
Criteria
NYSE, Amex and Sharpe ratio,
Ban et al. (2018) PBR
NASDAQ common stocks Turnover
Excess return,
Rasekhschaffe and Jones (2019) Stocks from 22 countries GBRT, SVM, AB, DNN
Alpha
VaR, Sharpe
Huck (2019) US Stocks DFN, RF, EN ratio, Max.
Drawdown
Sharpe ratio,
Huotari et al. (2020) S&P 500 stocks ANN, EIIE
p-value
Return
distribution,
Krauss et al. (2017) S&P 500 stocks DNN, GBRT, RF
VaR, Calmar
ratio
Cum. return,
Park et al. (2020) US and Korean ETFs LSTM, DNN, Q-Learning Sharpe ratio,
Turnover
Heaton et al. (2017) IBB Index Autoencoders Validation error
López de Prado (2016) Monte Carlo simulations HRP OOS variance
IR, MDD, VaR,
Yun et al. (2020) World ETFs PCA, LSTM
CVaR
IR, Sharpe ratio,
Raffinot (2017) S&P 500 stocks HRP
MDD
CVaR, Sharpe
Jain and Jain (2019) NIFTY 50 index HRP
Ratio
Cum. Return,
Tristan and Chin Sin (2021) Singapore Index AHC-DTW clustering
Sharpe ratio
Sharpe ratio,
Konstantinov et al. (2020) World Assets NN, LASSO regressions
MDD, CEQ
MAP, MDD,
Xue et al. (2018) Shanghai ETFs FFN, IMK-ELN
Sharpe ratio
MSE, RMSE,
UK Stock Exchange 100
Wang et al. (2020) LSTM+MVO MAPE, MAE,
Index
R2
Ta et al. (2020) S&P 500 stocks LSTM+MVO Sharpe ratio
Directional
Lee et al. (2019) World equity indices SVM
accuracy
Song et al. (2017) Selected US Stocks ListNet and RankNet (NN) Sharpe ratio
Vo et al. (2019) S&P 500 stocks LSTM+MVO MAE, RMSE
MAE, MSE,
Ma et al. (2020) China Securities 100 Index DMLP, LSTM, CNN
MDD
DMLP, LSTM, CNN, SVR, MAE, MSE,
Ma et al. (2021) China Securities 100 Index
RF MDD
Sharpe ratio,
Almahdi and Yang (2017) US and World ETFs RRL Calmar ratio,
Sterling ratio
Aboussalah and Lee (2020) Selected US Stocks SDDRRL Total return
Average return,
Paiva et al. (2019) Ibovespa stocks SVM
st.deviation

In Huotari et al. (2020), the main goal was to look at how modern ML analytics can help
with portfolio management, specifically by using an ANN-based system to automatically
detect market anomalies using technical analysis and exploiting them to maximize portfolio
returns by realizing excess returns. They used the Ensemble of Identical Independent
Evaluators (EIIE) architecture described by Jiang et al. (2017) on a sample of 415 stocks from
the S&P 500 Index and incorporated selected performance indicators for stock performance
in the analysis. They used reinforcement learning to create an ANN-based deep-learning
Risks 2022, 10, 84 32 of 46

(multi-layer ANN) agent model for portfolio management (trading model) for this study.
A reward function drove the agent model, and the objective was to maximize predicted
rewards over time.
Krauss et al. (2017) implemented and analyzed the effectiveness of several ML methods
in the context of statistical arbitrage. Specifically, they used DNNs, GBRTs, RFs and, finally,
a combination of them all. Each model was trained on lagged returns of all stocks in
the S&P500, after elimination of survivor bias. The database is comprised of daily data.
The empirical findings show that a simple ensemble of the three techniques produces a
significant excess of out-of-sample returns.
Park et al. (2020) proposed a novel long-only portfolio trading strategy in which an
intelligent agent is trained to identify an optimal trading action by using Deep Q-learning,
on of the most popular Deep Reinforcement Learning (DRL) methods. Compared with the
stochastic programming-based models (Monte Carlo simulations) and heuristic methods
(technical analysis), the authors defend that the proposed model, using daily data for two
different portfolio cases which comprises ETFs from the US stock market, is a superior
trading strategy relative to benchmark strategies.
Heaton et al. (2017) presented a four-step algorithm for model construction and
validation with special emphasis on building deep portfolios. In particular, they introduced
DL hierarchical decision models and provided a smart indexing example by auto-encoding
the IBB biotechnology index.
Yun et al. (2020) proposed a two-stage DL framework for portfolio management,
which uses LSTM for the prediction model, in addition to a cost function that addresses
both absolute and relative return. The proposed methods are evaluated with an ETF
dataset, and the empirical results show that the DL two-stage methods outperform ordinary
DL models.
In López de Prado (2016), we can find a very complete definition and explanation of
hierarchical methods, that address the main pitfalls of the Critical Line Algorithm (CLA),
the classical quadratic optimization procedure specifically designed by Markowitz in
1954 for inequality-constrained portfolio optimization problems, which was, at the time,
a brilliant solution to the generic-purpose quadratic programming models that did not
guarantee a correct solution after a known number of iterations. In particular, the author
presented the Hierarchical Risk Parity (HRP) method, which is based on graph theory and
ML techniques, and used the information in the covariance matrix without requiring its
inversion or positive definitiveness. The reason is that this new approach replaces the
covariance structure with a tree structure. By using Monte Carlo simulations, the author
demonstrates that, despite the CLA method delivering the minimum-variance portfolio,
the HRP produces lower out-of-sample variance portfolios.
Raffinot (2017) proposes a hierarchical clustering-based asset allocation method,
which uses graph theory and ML techniques, in a very similar way to López de Prado
(2016). Complete Linkage (CL), Average Linkage (AL) and Directed Bubble Hierarchical
Tree (DBHT) are among the hierarchical clustering approaches described and tested, us-
ing three empirical datasets from US Stock Market. AL and DBHT prove to be the best
clustering methods, and the clustered portfolios to achieve statistically better risk-adjusted
performance than commonly used portfolio optimization techniques.
In Jain and Jain (2019) we can find research which is also focused on the out-of-
sample performance of the portfolios, because it aims to test if there are any covariance
matrix forecasting techniques that outperform both traditional risk-based and ML-based
portfolios (such as HRP introduced by López de Prado (2016)) empirically. According
to their results, HRP is less sensitive to bad specifications of covariance than minimum
variance or maximum diversification portfolios, while it is less robust than an inverse
volatility weighted portfolio. The authors used daily prices from the individual stocks
comprising the NIFTY 50 from the Indian stock market.
The approach is very similar in Tristan and Chin Sin (2021), because it aimed to use
unsupervised time-series clustering-based ML techniques to diversify portfolios and over-
Risks 2022, 10, 84 33 of 46

come the varied outcomes of industry diversification. Specifically, they used shape-based
clustering approach for diversification, the Agglomerative Hierarchical Clustering algo-
rithm (AHC-DTW), applied to the daily prices of the top 82 stocks listed in the Singapore
equity market, and was demonstrated to clearly outperform industry diversification.
Another example of the use of hierarchical-based techniques is the work by Konstanti-
nov et al. (2020), that might be placed in an intermediate point between the financial areas
of factor investing and asset allocation. The aim of their work is to approach and com-
pare factor and asset allocation portfolios using both traditional and alternative allocation
techniques, considering centrality and hierarchical-based networks, specifically LASSO.
The monthly data used comes from the US stock market.
Xue et al. (2018) developed Incremental Multiple Kernel Extreme Learning Ma-
chine (IMK-ELM), which aims to enhance the efficiency of previous algorithms to make
classification tasks in robo-advisors services. Specifically, the novel algorithm is able to
handle heterogeneous customer information sets. The empirical results, reached through
simulation, show that IMK-ELM outperforms other generic classification methods.
Wang et al. (2020) suggested a hybrid approach consisting of LSTM networks and a
MVO model for optimum portfolio construction in combination with asset preselection,
in which long-term dependencies of financial time-series data may be represented. In this
sense, the empirical results show how LSTM clearly outperforms other ML techniques,
such as SVM, RF and common DNNs. In the second stage, after selecting asset with
higher returns according to that ML technique, the MVO model is applied for portfolio
optimization. The monthly data used comes from the UK Stock Exchange 100 Index.
Ta et al. (2020) implemented ML techniques at a double level. First, they use LSTM,
an special type of RNN, to forecast stock direction based on historical data. In the second
level, and in order to build an efficient portfolio, they make use of multiple optimization
techniques, including Equal-weighted modeling (EQ), Monte Carlo simulation (MCS) and
MVO. The results show that the LSTM prediction model works efficiently by obtaining
high accuracy from stock prediction, and generating portfolios which outperform those
obtained using alternative techniques as Logistic Regression (LR) or SVM. The data used in
this work are the 10-year daily historical stock prices of 500 large-cap stocks listed on the
America Stock Exchange S&P500.
The approach in Lee et al. (2019) is very similar to those aforementioned in the sense
of using a double-scale framework. In this case, the first level of the trading strategy is
based on the effect and usefulness of networks indicators. Using a Vector Autorregression
model (VAR) model, they forecasted global and regional stock markets’ directions. Once
these trend predictions were defined, they were used as inputs for determining portfolio
strategies via several ML techniques, such as LR, SVM, and RFs. The research data are
daily stock index prices from 10 different countries over a period of 22 years. The empirical
results show that the prediction accuracy and profit performances are enhanced with
network indicators, and that the SVM approach displays the best performances.
Song et al. (2017) focused their attention on the area of investors’ sentiment. In par-
ticular, they showed that learning-to-rank algorithms are effective in producing reliable
rankings of the best and worst performing stocks and, according to them, they are able to
implement outperforming portfolio strategies which produce risk-adjusted returns superior
to the benchmark. The algorithms used with weekly prices and financial news from US
Stock market are called RankNet and ListNet, which are supervised learning approaches
that relies on NNs and Gradient Descent Optimization (GDO) techniques.
The work by Vo et al. (2019) enters into the emerging field of Socially Responsible
Investments (SRIs). The authors defend that traditional optimization methods for portfolio
management are inadequate for this kind of investments, so they propose a new model
called Deep Responsible Investment Portfolio (DRIP) that contains a Multivariate Bidirec-
tional LSTM neural network to predict stock returns for the construction of a SRI portfolio
using the MVO model. For the empirical application, they used daily closing prices of all
individual stocks contained in the S&P500 from the past 30 years. The portfolios obtained
Risks 2022, 10, 84 34 of 46

using this method had a high degree of accuracy and achieved much higher Environmental,
Social and Governance (ESG) ratings compared with standard MVO models.
Ma et al. (2020) used the most common DL techniques to build prediction-based
portfolio optimization models. These models start by using DNNs to forecast each stock’s
future performance. The risk of each stock is then calculated using DNNs predictive errors.
Following that, portfolio optimization models are constructed by combining predicted
returns and semi-absolute deviation of prediction errors. These models are contrasted
against three equal-weighted portfolios, with stocks picked by DMLP, LSTM, and CNN,
respectively. Additionally, two SVR-based portfolio models are utilized as benchmarks.
As experimental data, this article uses component stocks of the China Securities 100 index in
the Chinese stock market. The prediction-based portfolio model based on DMLP performs
the best among these models.
The approach is very similar in Ma et al. (2021), where the authors propose two
ML models, specifically RF and SVR, and three DL models, in particular DMLP, LSTM,
and CNN, for stock preselection before portfolio construction. Therefore, they incorporates
those results in advancing MVO models. As benchmarks, they utilize portfolio models
with Autorregressive Integrated Moving Average (ARIMA) predictions. Once evaluated
the models with daily data from the Chinese Stock market index, the results show that
portfolio models with RF predictions are the best among the set of models used.
Almahdi and Yang (2017) applied RRL techniques to build an optimal variable weight
portfolio allocation. For this purpose, they propose a RRL with a coherent risk adjusted
performance objective function, based on the expected maximum drawdown, the Calmar
ratio. They use as dataset five asset portfolios built with five of the most commonly traded
ETFs. The maximized function using this method yields superior return performance than
other techniques proposed in the existing literature.
Similarly, using RRL techniques, Aboussalah and Lee (2020) aimed to enter into the
field of continuous action and multi-dimensional state spaces, and, hence, they propose
the called Stacked Deep Dynamic Recurrent Reinforcement Learning (SDDRRL) to build a
real-time optimal portfolio. As performance metric, they use the Sharpe ratio. The model
was trained and tested with daily data from the S&P500 index, and the results showed that
their model outperforms three different benchmarks, including MVO model.
In Paiva et al. (2019), again, the two-pass methodology is applied to get a portfolio
selection model. First, they apply a ML technique to make stock price predictions, the SVR
method. After that, they use the traditional scope of MVO for portfolio construction. They
compare the results of this method with benchmarks applied to the daily prices of the
individual assets included in the Ibovespa index, and the results are favourable for the
proposed technique.

5.4. Price Forecasting

Return and price forecasting play a main role in modern portfolio theory, in asset
pricing models and, from a practical point of view, in the asset management industry. As it
was pointed out by Gu et al. (2020), because the primary objective of asset pricing is to
understand the behavior of risk premiums, return prediction is economically significant.
In academic finance, the terms expected return and risk premium have been usually
interchanged.
As Henrique et al. (2019) pointed out, the challenge of predicting asset prices and the
search for models and profitable systems is still attractive for both the academia and the
financial professionals despite the strong presence of the efficient market hypothesis (EMH)
by Malkiel and Fama (1970), which defends that most of the financial asset prices follow,
statistically, a random walk process, and therefore are almost unpredictable.
The recent literature facing the use of ML techniques has been summarized in Table 5
and can be divided, roughly, into two levels. In the first level, the new ML technology
has been applied to enhance forecasts made using traditional inputs, such as fundamental
accounting data, macroeconomic data, or technical indicators. In other words, improving
Risks 2022, 10, 84 35 of 46

the results of econometric and time-series analysis using fundamental and technical ap-
proaches. In the second level, ML has been used to extract new inputs form alternative
data, such as sentiments from news data.

Table 5. Selection of papers for price forecasting. Mean Absolute Error (MAE), Mean Standard Error
(MSE), Maximum Drawdown (MDD).

Performance
Author Target Market Method
Criteria
SVM, RF, KNN, NB, Accuracy,
Kumar et al. (2018) Selected Indian stocks
Softmax F-measure
Total return,
Lee and Kang (2020) S&P 500 stocks MLP, CNN
MDD
Average
Cervelló-Royo and Guijarro (2020) Nasdaq 100 stocks GBM, RF, CNN
accuracy ratio
DT, RF, KNN, LR, ANN, Accuracy,
Nabipour et al. (2020) Selected Indian stocks
RNN, LSTM F-measure
Zhong and Enke (2019) S&P 500 ETFs DNN, FFNN MSE
Overall
Shen and Shafiq (2020) Selected Chinese stocks CNN, LSTM
accuracy
ANN, SVM, RF, RNN, MAE, MSE,
Nikou et al. (2019) iShares MSCI UK ETFs
LSTM RMSE
Overall
Minh et al. (2018) S&P 500 index RNN, TGRU, LSTM
accuracy
Ding et al. (2015) S&P 500 index WB+CNN Total return
Accuracy,
GNB, SVM, LR, MLP, KNN,
Khan et al. (2020) Selected US stocks precision, recall,
GBM, RF
F-measure

Within the first category, we can cite Kumar et al. (2018), where the authors analysed
various Supervised Learning (SL) techniques for stock market prediction. Specifically, they
consider SVM, RF, K-Nearest Neighbor (KNN), Naive Bayesian Classifier (NV), and Soft-
max. Five models were developed and their performances compared in predicting stock
market trends. According to their results, the RF algorithm performed the best for large
datasets, while NV showed the best performance for small datasets. Moreover, they found
that the reduction of technical indicators reduces the accuracy of each algorithm.
Lee and Kang (2020) proposed a novel method for training NNs to forecast the future
prices of stock indexes. The main contribution of their work is to use only the data of
individual companies -instead of index data- to obtain sufficient amount of data for training
NN for the prediction of stock indexes. Their experiments, focused on S&P 500, show that
NN trained this way outperform NN trained on stock index data. Specifically, they obtain
a 5–16% annual return before transaction costs during the period 2006–18.
To evaluate the predictive capacity of certain popular technical indicators in the
technological NASDAQ index, in Cervelló-Royo and Guijarro (2020) the authors compared
the performance of four ML algorithms: RF, Deep Feedforward Neural Network (DFNN),
GBRT and Generalized Linear Model (GLM). The results show that the RF algorithm beats
the other ML algorithms, forecasting the market trend 10 days ahead with an average
accuracy level of 80%.
Nabipour et al. (2020) seeked the reduction of risk in trend prediction using ML and
DL techniques, and applying 11 ML logarithms to data from the Tehran stock exchange.
They used DT, RF, AB, eXtreme Gradient Boosting (EGB), SVM, NV, KNN, LR and ANN
as ML algorithms and RNN and LSTM as DL ones. The analysis findings show that RNN
and LSTM beat other prediction models for continuous data by a significant margin.
Zhong and Enke (2019) focused their analysis on daily stock market returns, specifi-
cally in the SPDR S&P ETF prices. To anticipate the daily direction of future stock market
index returns, DNNs and ANNs were applied to the full preprocessed but untransformed
dataset, as well as two datasets transformed through principal component analysis (PCA).
The simulation findings demonstrate that DNNs with two PCA-represented datasets,
Risks 2022, 10, 84 36 of 46

as well as numerous other hybrid machine learning methods, have considerably greater
classification accuracy than those with the full untransformed dataset.
Shen and Shafiq (2020) propose a solution for the Chinese stock market prices pre-
diction which consists of a feature engineering along with a fine-tuned system based on a
LSTM model. The feature engineering applied are the Feature Expansion (FE) approaches
with Recursive Feature Elimination (RFE), followed by PCA. This proposed solution
outperforms the ML and ML-based models in similar previous works.
In Nikou et al. (2019), the authors want to examine how well ML models can forecast
the daily close price data of the iShares MSCI United Kingdom ETF. Four models of ML
algorithms are used in the prediction process. The results indicate that the RNN and LSTM
DL methods are better in prediction than the other ML methods, and the SVM method is in
the next rank with respect to ANN and RF methods, according to error prediction.
Within the second category, we can cite Minh et al. (2018). This study is focused on
the financial news as potential factor which causes fluctuations in stock prices. The main
contribution of the paper is to propose a novel framework to forecast directions of stock
prices by using both financial news and sentiment dictionary, specifically a novel two-
stream GRU and Stock2Vec, a sentiment word embedding trained on financial news dataset.
Ding et al. (2015) suggested a DL method for event-driven stock market prediction.
Events are first retrieved from news content and represented as dense vectors using an
Neural Tensor Network (NTN). Second, a Deep Convolutional Neural Network (DCNN)
is utilized to predict both short- and long-term effects of events on stock price fluctuations.
When compared to state-of-the-art baseline approaches, experimental findings demonstrate
that their model can enhance S&P 500 index prediction and individual stock prediction by
nearly 6%.
Khan et al. (2020) utilized algorithms to examine the influence of social media and
financial news data on stock market forecast accuracy over a ten-day period. To increase
prediction performance and quality, feature selection and spam tweets reduction are carried
out on the data sets. Finally, DL is implemented to achieve maximum prediction accuracy,
and certain classifiers are ensembled. The highest forecast accuracies of 80.53% percent and
75.16%, respectively, were reached utilizing social media and financial news, according
to their findings. RF classifier is found to be consistent and highest accuracy of 83.22% is
achieved by its ensemble.
Similarly, Khan et al. (2020) sought to know whether public opinion and political en-
vironment in Pakistan on any given day may influence stock market patterns in individual
firms or the whole market. Ten ML algorithms were applied to the final data sets to predict
the stock market future trend. The experimental findings suggest that the sentiment feature
increases machine learning algorithm prediction accuracy by 0–3%, whereas the political
situation feature improves algorithm prediction accuracy by around 20%. The Sequential
Minimal Optimization (SMO) algorithm was identified to have the best performance.

5.5. Algorithmic Trading

It is not easy to classify this discipline. Although it might be classified within one
of the areas aforementioned, mainly price forecasting, we have thought that it has some
characteristics that may justify to be defined into an independent category.
Algorithmic Trading can be defined as “buy-sell decisions made solely by algorithmic
models”, as cited in Ozbayoglu et al. (2020). These decisions can be based on some simple
rules, mathematical models, optimized processes or, as in the case of ML and DL, highly
complex function approximation techniques. Market making, inter-market spreading,
arbitrage, and pure speculation such as trend following are examples of methods employed
in algorithmic trading. Many fall into the category of high-frequency trading (HFT), which
is characterized by high turnover and high order-to-trade ratios.
In the case of trend-following methods, many times algorithmic trading applications
are connected to price forecasting methods. Consequently, most price forecasting models
that generate buy-sell signals based on their forecast are likewise classified as Algo-trading
Risks 2022, 10, 84 37 of 46

systems. Obviously, we will refrain from analyzing those papers focused on price fore-
casting again. However, most of times Algo-trading is coupled with technical analysis,
which means that, from a conceptual point of view, this discipline is poorly connected
with Finance theory and Financial Economics. Nonetheless, and given the great symbiosis
between algorithmic systems and ML techniques, we will make a very brief review of
the most interesting papers within this emerging and very popular field among financial
market practitioners. This review has been condensed in Table 6.

Table 6. Selection of papers for algorithmic trading.

Author Target Market Method Performance Criteria

Sezer et al. (2017) Dow 30 stocks MLP-ANN Overall accuracy
Troiano et al. (2018) Dow 30 stocks LSTM Overall accuracy
Sirignano and Cont (2019) Selected US stocks LSTM Overall accuracy
Tsantekidis et al. (2017) Selected Finnish stocks CNNs Recall, precision, F1
Sezer and Ozbayoglu (2018) World ETFss CNNs Annualized returns
Niño et al. (2018) Selected US stocks CNNs Directional accuracy
Tsantekidis et al. (2017) Selected Finnish stocks LSTM Recall, precision, F1

Sezer et al. (2017) proposed a stock trading system based on optimized technical
analysis parameters for creating buy-sell points using genetic algorithms. The optimized
parameters were then used to a DMLP for buy-sell-hold predictions. Daily prices of Dow 30
stocks were used. The results show that this method enhances the stock trading performance.
Troiano et al. (2018) employed a LSTM based on market indicators, in particular,
the Moving Average Convergence and Divergence (MACD) signals, to forecast the trend of
the Dow 30 stocks’ daily prices. Using also LSTM, Sirignano and Cont (2019) proposed a
novel method that used limit order book flow and history information for the determination
of the stock movements. The same approach can be found in Tsantekidis et al. (2017).
Due to their effectiveness in image classification problems, several research papers
have focused on using CNNs-based models. To do so, however, the financial input data
have to be converted into images, which demands some creative preprocessing. It is the
case of Sezer and Ozbayoglu (2018), who presented a new method for converting financial
time-series data containing technical analysis indicator outputs to 2-dimensional images
and classifying these images using CNNs to derive trading signals. Using the Limit Order
Book Data and transaction data, Niño et al. (2018) encoded financial time-series into an
image-like representation, and get a very good performance in terms of directional accuracy.
Tsantekidis et al. (2017) proposed a novel method that uses the last 100 entries form the
limit order book to create a 2-dimensional image for the stock price prediction.

6. Discussion
After reviewing the selected datasets, methods, and performance criteria, we will take
a step back to analyze them at a higher level of abstraction. This discussion will comprise
three aspects: firstly, we will provide an overview of the state of the art of ML for asset
management; second, we will highlight the most successful data, methods, and criteria
for each financial discipline we reviewed; at last, we will lay down the existing challenges
which might motivate further research.

6.1. Overview
The traditional approach to solving asset management issues has been the focus
of academics and practitioners alike throughout the last 50 years. However, it has also
exhibited many drawbacks. Next, we will describe shortly the main pitfalls and challenges
that this discipline is currently addressing:
• Researchers are sometimes compelled to present incomplete results that are often
refuted by additional studies due to the publication bias towards successful results
Risks 2022, 10, 84 38 of 46

(see Harvey 2017). As a result, replication is critical, and many academic findings
have a very short expiration date, especially if transaction costs are taken into account
Cakici and Zaremba (2021).
• One of the main pitfalls of the traditional econometric approach has to do with the
p-hacking. As it was demonstrated by Chen (2019), p-hacking alone cannot account
for all the anomalies documented in the literature. One way to reduce the risk of
spurious detection is to increase the hurdles (often, the t-statistics) but the debate
whose title might be “the factor zoo” is still ongoing Harvey and Liu (2019).
• Because of its easy understanding, the decomposition of returns into linear factor
models is extremely useful. Nonetheless, there is an eternal dispute in the academic
literature as to whether business returns are explained by exposure to macroeconomic
variables or merely by firm characteristics. Until the new century the factor-based
explanation for risk premium was the favourite, but after the seminal work by Daniel
and Titman (1997), the characteristics-based explanation has become a great competitor
of the traditional outlook.
• Some researchers have observed fading anomalies as a result of publication: once
an anomaly is made public, agents invest in it, driving up prices and causing the
anomaly to vanish. David McLean and Pontiff (2016) documents this impact in the
United States, while Jacobs and Mülle (2020) finds that post-publication factor returns
are sustained in other relevant markets. Herding may be destroying factor premia
Krkoska and Schenk-Hoppé (2019), and the democratization of so-called smart-beta
products (particularly the ETFs) that enable investors to actively invest in specific
styles (value, low volatility, etc.) may speed the process up.
• Researchers have developed more sophisticated techniques to organize the so-called
factor zoo and, more significantly, to detect false anomalies. Feng et al. (2020), for ex-
ample, uses LASSO selection and Fama–MacBeth regressions to see if new factor
models are worthwhile. They calculate the benefit of adding one new factor to a set of
preset factors, demonstrating that many of the factors described in papers published
in the 2010 decade do not provide much extra value.
• There is no such thing as a flawless approach, but the sheer volume of contributions
in the field emphasizes the importance of robustness. The notion that factors are likely
to change over time is a key obstacle for short-term strategies. We refer for instance to
Cooper and Maio (2019).
• As we have seen in the Section 5.4 about price forecasting, the difficulty to test con-
sistently, using traditional approaches, the EMH, leaves a huge space to alternative
techniques.
• In the case of MVO, as Cochrane (2011) points out, even though it is not a particularly
useful guide to computation, classic one-period mean-variance analysis is a brilliantly
useful characterization of an optimal portfolio, useful for final investors to understand
and think hard about risk allocations. Even when investors are considering highly non-
normal payoffs, traditional mean-variance analysis continues to dominate portfolio
applications. Nevertheless, many researchers have tried to improve the suitability of
this model from different perspectives.
In conclusion, traditional financial economics has no perfect answers to all these pit-
falls and challenges described. On the other hand, ML techniques have found an excellent
breeding ground to develop all its potentialities. As Cerniglia and Fabozzi (2020) points
out, financial theory, market behavior, ever-increasing data sources, and computational
innovation are all required for good forecasting and pricing. By putting together the most
comprehensive toolbox, you can create realistic computational models. This goal may be
achieved using both financial econometrics and ML techniques. According to these au-
thors, ”ML tools provide the ability to make more accurate predictions by accommodating
nonlinearities in data, understanding complex interaction among variables, and allowing
the use of large, unstructured datasets. The tools of financial econometrics remain criti-
cal in answering questions related to inference among the variables describing economic
Risks 2022, 10, 84 39 of 46

relationships in finance; when properly applied, their role has not diminished with the
introduction of ML”.
As we have reviewed, and according to Song et al. (2017), ML algorithms are commonly
employed for financial market forecast and trading strategies. There are three different sorts
of applications. The first sort of application forecasts asset prices or returns in the future.
Generally, SVR and NN algorithms are used in this type of strategies. The drawback with
this strategy is that it has a high error rate owing to the difficulty in predicting future asset
values based on erratic financial market data. The second type uses classification algorithms
to anticipate price movement directions, such as SVM and DTs. These approaches generally
have significant forecast accuracy, but this does not always imply high profitability. For
example, a model can anticipate small gains properly but massive losses wrongly, resulting
in a substantial downside risk. Rule-based optimization is the third type. Its goal is to find
the best trading indicator and parameter combinations (for example, technical indicators,
fundamental indicators, and macroeconomic indicators). Optimization algorithms that
have been explored include Gaussian Process (GP) and RL.
To sum up, the trend indicates that ML algorithms clearly outperform traditional
econometrics approaches. However, the landscape is extremely diverse in terms of data
and applied methods, which suggests a lack of common benchmarks, methodologies,
and frameworks. Both classical and modern ML methods have been applied successfully.
The high number of applications of LSTMs models is especially remarkable where time-
series come into play.

6.2. Discipline Focus

After providing an overview for the field as a whole, we will increase our focus to
discuss each one of the reviewed disciplines (including the extra algorithmic trading) from
the ML perspective.
• Value/Factor investing: The landscape is not specifically dominated by any particular
technique. PCA is successful in most works as a pre-processing technique whilst other
classical ML methods like RFs, SVMs, or shallow NNs are present in almost all the
analyzed works. RNNs does not have much presence in this discipline. The paradigms
are mainly Supervised Learning and Unsupervised Learning.
• Portfolio Management: In this discipline, we observed a trend of favoring RNNs archi-
tectures to model long-term dependencies of financial time-series data. In particular,
most of the reviewed methods make use of variations of LSTMs (usually combining
them with other techniques like MVO). RL methods appear in this discipline coupled
with RNNs in the form of LSTMs in the most recent works. The dominant paradigms
are Supervised Learning (SL) and Reinforcement Learning (RL).
• Price Forecasting: The most heterogeneous discipline where all sorts of ML methods
have been applied to either refine the output of other algorithms, to generate predic-
tions on its own or even as a technique to process alternative data sources. A few
works make use of social media, financial news, and sentiment analysis to increase
prediction accuracy. There is no dominant paradigm in this discipline.
• Algorithmic Trading: In this case, most reviewed papers make use of SL to train
architectures more typically suited to target other domains. For instance, CNNs (which
are common in image processing scenarios) are applied to specially pre-processed
financial data with success. Oftentimes, they are also coupled with RNNs techniques
to model time dependencies, usually applying LSTMs.

6.3. Challenges and Future Research

We have identified the following main challenges and opportunities:
• Standard Datasets: The whole field is characterized by a lack of curated datasets to
be reused by the community. Although some datasets are built upon the portfolio
database of Fama and French (1993), most of them deviate from this standard. Further-
more, even those which reuse that database end up diverging in terms of the final data
Risks 2022, 10, 84 40 of 46

available for investigation. Therefore, creating a standard database (complete and

broad enough) to be reused by the research community is a need for further works.
• Reproducibility: No common methodology or framework for method training and
benchmarking has been established. This hurts reproducibility since most of the ana-
lyzed methods are difficult, if not impossible, to compare against each other (unless
reimplemented specifically for each scenario). In addition, almost no paper includes
codes or data to be accessed by other researchers. Establishing a reproducibility frame-
work for asset management ML research is a high-impact workstream for improving
the quality of life and pace of the research community.
• Multimodal Data: Most methods are focused on analyzing numerical financial data to
generate predictions. Analyzing alternative sources of information like news, social
media, sentiment, and user-generated content can provide useful cues for financial
decisions. Few works make use of those data sources at the moment. The challenge of
combining all those multimodal sources and multiple architectures might unlock new
levels of prediction accuracy.
• Heterogeneous Architectures: Arguably due to the state of immaturity in which
financial ML sits nowadays (with regard to other more established synergies like
image processing or NLP), no clear architectures for processing financial data have
been established yet. There is a broad range of papers that spawn new models, and few
that build upon solid groundwork to improve them. Finding the common patterns and
unifying those diverse architectures could have a beneficial effect to the community
for broad adoption in industry (in a similar way as other networks, such as UNet
or ResNet, have done for image processing by becoming the de facto standard for
many applications).
• Algorithmic trading: This application field is characterized by a very interesting
trade-off. From an academic perspective, this area is relatively disconnected from
the theoretical background about asset pricing and value investing, which has had a
central role in financial economics during the last five decades, and it has been sum-
marized in Section 3. However, in return, and precisely because of this characteristics—
exclusive dependence on price data—it is the financial discipline that can maximize
the contributions of ML applications. We can find a future challenge in the possibility
of combining both issues, deepening trading algorithms with a higher relevance of
financial fundamentals.

7. Conclusions
To the best of our knowledge, this is the first review paper in the literature which
focuses on asset management using ML. In comparison with other papers, which are
either broader (tackling finance as a whole) or narrower (portfolio management), this
paper is devoted to an intermediate area which is of great interest for both academics and
practitioners, but has not yet been reviewed and structured adequately. We formulated the
asset management problem and broke it down into disciplines, providing the reader with
enough background knowledge to either get familiar with the area or acquire a standard
terminology. Furthermore, we also provided a background on ML for the more finance-
oriented audience. We covered the contemporary literature of datasets and methods,
creating a comprehensive review of 12 sources of data and more than 50 techniques. We
also discussed the criteria that have been applied throughout them to train and measure
their performance. In the end, we discussed the reviewed methods and datasets and
provided useful insight in the shape of future research directions and open challenges in
the field.

Author Contributions: Conceptualization, P.M.M.-F., A.G.-G., J.S.B.-S. and M.A.P.; methodology,

P.M.M.-F. and A.G.-G.; software, P.M.M.-F. and A.G.-G.; validation, P.M.M.-F. and A.G.-G.; formal
analysis, P.M.M.-F. and A.G.-G.; investigation, P.M.M.-F. and A.G.-G.; resources, P.M.M.-F. and
A.G.-G.; data curation, P.M.M.-F. and A.G.-G.; writing—original draft preparation, P.M.M.-F. and
A.G.-G.; writing—review and editing, P.M.M.-F. and A.G.-G.; visualization, P.M.M.-F. and A.G.-G.;
 Risks 2022, 10, 84 41 of 46

supervision, J.S.B.-S. and M.A.P.; project administration, M.A.P.; funding acquisition, P.M.M.-F.
All authors have read and agreed to the published version of the manuscript.
Funding: This research has been funded by Faculty of Economics and Business Administration
(ICADE), Universidad Pontificia Comillas.
Institutional Review Board Statement: Not applicable.
Informed Consent Statement: Not applicable.
Conflicts of Interest: The authors declare no conflict of interest.

Notes
1 The term “stochastic discount factor” is used because m generalizes standard discount factor ideas. If there is no uncertainty,
we may use the conventional present value formula to describe prices
1
pt = x
1 + r d t +1

where rd is the risk free rate, the return of a discount bond with a unique and riskless payoff of 1 dollar in the period t + 1.
2 An investor’s first order conditions give the basic consumption-based model, in which the pricing kernel or SDF can be expressed
as:
u0 (c )
m t +1 = δ 0 t +1
u (ct )
where ct denotes the level of consumption in period t, u the utility function and δ the elasticity of intertemporal substitution of
consumption.
3 In the consumption-based model already described, it means that investors are risk neutral, i.e., u(c) is linear or there is no
variation in consumption, and we are in short time horizons where δ is close to one.
4 The alpha component is, according with the different factor models we have exposed, the independent term which is not
associated with any factor of risk and, supposedly, can be associated with the skill of the investors to find extra returns in the
securities they invest in.

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