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The Optimal Use of Return Predictability: An Empirical Analysis

Last Updated on 10 February, 2024 by Rejaul Karim

The research paper “The Optimal Use of Return Predictability: An Empirical Analysis” by Abhay Abhyankar, Devraj Basu, and Alexander Stremme delves into the empirical performance of unconditionally efficient portfolio strategies using several popular predictive variables.

Drawing upon the works of Hansen and Richard (1987) and Ferson and Siegel (2001), the researchers assess the effectiveness of these strategies by maximizing various ex-post performance measures through both in-sample and out-of-sample analysis.

By examining the economic value of distinct predictor variables and their combinations, the study aims to improve investor understanding of the risk-return tradeoff in relation to fixed weight strategies. The research findings underscore the advantages of incorporating conditioning information in optimizing portfolio performance, evident across various efficiency measures including Sharpe ratios and measures of economic value such as switching costs.

Additionally, through a comparative analysis of unconditionally and conditionally efficient strategies, the study highlights the contrasting performance outcomes stemming from distinct portfolio weight responses to conditioning information.

Abstract Of Paper

In this paper we investigate the empirical performance of unconditionally efficient portfolios strategies for a number of commonly used predictive variables. These strategies, which optimally utilize asset return predictability in portfolio formation were studied by Hansen and Richard (1987) and Ferson and Siegel (2001). Our criterion is to maximize various ex-post performance measures and we conduct both in-sample as well as out-of-sample analysis. Our analysis allows us to determine the economic value of using different predictor variables and also groups of predictor variables.

Overall we find that the optimal use of conditioning information significantly improves the risk-return tradeoff available to a mean-variance investor relative to fixed weight strategies. These findings are consistent across portfolio efficiency measures such as Sharpe ratios, portfolio variance subject to a mean constraint or portfolio mean subject to a volatility constraint as well as measures of economic value such as switching costs.

In addition we also compare the performance of the unconditionally efficient strategies with conditionally efficient strategies from an investment-based perspective. We find that the performance of the two strategies is quite different due to the differing response of the portfolio weights of the two strategies to conditioning information.

Original paper – Download PDF

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Author

Abhay Abhyankar
MOVE,Departament d’Economia i d’Història Econòmica, Universitat Autònoma de Barcelona

Devraj Basu
SKEMA Business School – Lille Campus

Alexander Stremme
University of Warwick – Finance Group

Conclusion

To conclude, the research paper “The Optimal Use of Return Predictability: An Empirical Analysis” by Abhay Abhyankar, Devraj Basu, and Alexander Stremme provides a comprehensive investigation into the empirical performance of unconditionally efficient portfolio strategies using widely recognized predictive variables.

The study demonstrates that integrating conditioning information substantially enhances the risk-return tradeoff for mean-variance investors when compared to fixed weight strategies. This improvement is consistently observed across various portfolio efficiency measures, including Sharpe ratios and economic value metrics such as switching costs.

Furthermore, the researchers offer a comparative analysis between unconditionally and conditionally efficient strategies, which unveils contrasting performance results arising from divergent portfolio weight responses to conditioning information. This illuminating study contributes to an advanced understanding of asset return predictability and its implications in constructing informed and effective investment strategies.

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FAQ

Q1: What is the main focus of the research paper by Abhyankar, Basu, and Stremme?

The research paper explores the empirical performance of unconditionally efficient portfolio strategies using various predictive variables. It assesses the effectiveness of these strategies by maximizing ex-post performance measures through both in-sample and out-of-sample analyses.

Q2: What is the criterion used in the analysis, and what does the study aim to determine?

The criterion for analysis is to maximize various ex-post performance measures. The study aims to determine the economic value of different predictor variables and groups of predictor variables in optimizing portfolio performance.

Q3: What are the key findings regarding the use of conditioning information in portfolio formation?

The research finds that the optimal use of conditioning information significantly improves the risk-return tradeoff for mean-variance investors compared to fixed weight strategies. This improvement is consistent across various portfolio efficiency measures, including Sharpe ratios, and economic value metrics such as switching costs.

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