Robust Reverse Engineering of Cross Sectional Returns and Improved Portfolio Allocation Performance Using the CAPM
East China University of Science and Technology (ECUST)
University of Saint Etienne - Graduate School of Economics and Business Administration (ISEAG); EM Lyon (Ecole de Management de Lyon) - Department of Economics, Finance, Control
Swiss Finance Institute; ETH Zurich
University of Zurich
January 30, 2011
Swiss Finance Institute Research Paper No. 11-03
Following Levy and Roll , we posit that the market portfolio is the efficient tangent Markowitz portfolio, i.e., it is mean-variance efficient. We then reverse engineer the expected returns and variance terms with constraints imposed by empirical data on a hierarchy of asset baskets. This extends the results of Levy and Roll  and shows that only minor adjustments of the input parameters are needed, well within the statistical uncertainties. Applying the Levy-Roll procedure to the 25 Fama-French portfolios sorted by sizes and book-to-market values, we check the consistency of the Levy-Roll approach by investigating how the adjusted stock returns of specific stocks are modified when varying the basket of stocks they belong to. We test the dynamical performance of the Levy-Roll procedure over the period from January 1992 to December 2009 and find that the corresponding dynamical portfolio allocation performs significantly better than standard benchmarks.
Number of Pages in PDF File: 18
Keywords: CAPM, Mean-Variance Portfolio Optimization, Constrained Optimization, Fama-French, Value-Size Portfolios, Dynamical Allocation, Expected Returns
JEL Classification: G11, G12working papers series
Date posted: February 1, 2011
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