This paper studies the economic benefits of return predictability by analyzing the impact of market and volatility timing on the performance of optimal portfolio rules. Using a model with time-varying expected returns and volatility, we form optimal portfolios sequentially and generate out-of-sample portfolio returns. We are careful to account for estimation risk and parameter learning. Using S&P 500 index data from 1980-2000, we find that a strategy based solely on volatility timing uniformly outperforms market timing strategies, a model that assumes no predictability and the market return in terms of certainty equivalent gains and Sharpe ratios. Market timing strategies perform poorly due estimation risk, which is the substantial uncertainty present in estimating and forecasting expected returns.
Showing posts with label Portfolio. Show all posts
Showing posts with label Portfolio. Show all posts
Wednesday, May 23, 2007
Sequential Optimal Portfolio Performance: Market and Volatility Timing
This paper studies the economic benefits of return predictability by analyzing the impact of market and volatility timing on the performance of optimal portfolio rules. Using a model with time-varying expected returns and volatility, we form optimal portfolios sequentially and generate out-of-sample portfolio returns. We are careful to account for estimation risk and parameter learning. Using S&P 500 index data from 1980-2000, we find that a strategy based solely on volatility timing uniformly outperforms market timing strategies, a model that assumes no predictability and the market return in terms of certainty equivalent gains and Sharpe ratios. Market timing strategies perform poorly due estimation risk, which is the substantial uncertainty present in estimating and forecasting expected returns.
US Portfolio Strategy
As I travel around and visit with a growing number of Morgan Stanley accounts, it has become clear to me that hedge fund managers — particularly emerging ones with limited assets — are increasingly trafficking in smaller-capitalization US stocks. But it helps to get a second opinion. To this end, my colleague Bill Smith built a database of hedge fund 13F filings. What we found is that hedge fund ownership of mega/large-cap stocks has fallen to 36% in 4Q05 from 48% in 1Q99. Probably more interesting to the typical man on the street, however, is that there is a lot of money to be made by tracking which specific stocks hedge funds own.
Portfolio Strategy: Alpha Returns and Active Extensions
The relaxation of the long-only constraint within equity portfolios and the subsequent move into an active extension “120/20 strategy” can lead to material improvements in both alpha returns and alpha/tracking error (TEV) ratios. These potential benefits can be estimated by combining an alpha ranking system, a position weighting function, and a tracking error model.
Portfolio Strategy
Stock market valuation without reference to risk is insufficient to make sound investment decisions. However, finding accurate measures of the level of risk associated with a security is not a trivial enterprise in emerging markets. First, high levels of market volatility make measures based on contemporaneous market indicators highly unstable. Second, the limited history of bond market prices in emerging markets makes it impossible to ascertain any long-term trends in risk.
Beyond Portfolio Theory: The Next Frontier
The time has come to integrate the insights offered by information theory and principal–agent theory with the tools of portfolio management into a holistic, comprehensive theory of investing.
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