Global CAPE Model Optimization

Abstract:     
We use the Shiller CAPE Model proposed by Mebane Faber as a template for the exploration of a variety of portfolio optimization methods. By virtue of the Model's systematic allocation to the 'cheapest' markets with the highest theoretical risk premia, the model has the potential to extract high costs from 'behavioural taxes' related to the model’s extreme volatility and drawdown character. We apply several portfolio optimization techniques with the objective of maximizing portfolio Sharpe ratios and minimizing drawdowns, including dynamic volatility weighting, risk parity, target risk and minimum variance. Consistent with recent published research on robust portfolio optimization, return to risk ratios improve broadly, with the greatest impact achieved from procedures that manage positions and/or portfolios to an ex ante target volatility. A theoretical framework is also proposed.

Number of Pages in PDF File: 17

Keywords: CAPE, Shiller, Faber, Butler, Philbrick, Gordillo, GestaltU, Portfolio Optimization, Volatility, Risk Parity, Minimum Variance, Target Volatility, Risk Budget, Volatility Budget, Low Volatility Anomaly

working papers series