Abstract

http://ssrn.com/abstract=687083
 
 

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The Optimal Use of Return Predictability: An Empirical Analysis


Devraj Basu


Université Lille Nord de France - Skema Business School

Abhay Abhyankar


University of Exeter Business School, University of Exeter

Alexander Stremme


University of Warwick - Finance Group

March 2005

AFA 2006 Boston Meetings Paper

Abstract:     
In this paper we study the economic value and statistical significance of asset return predictability, based on a wide range of commonly used predictive variables. We assess the performance of actively managed portfolios strategies which optimally exploit such predictability, both in-sample as well as out-of-sample. Such strategies were first studied by Hansen and Richard (1987) and Ferson and Siegel 2001. Our criterion is to maximize various ex-post performance measures, including maximum Sharpe ratio, utility premia, and transaction costs. We develop a test statistic, based on the difference in maximum Sharpe ratio, that has both an intuitive economic interpretation as well as known statistical properties. We are thus able to assess the statistical significance of the economic gains from predictability. Our analysis allows us to compare and rank different predictor variables and also groups of predictor variables.

Overall we find that the optimal use of conditioning information does indeed significantly improve the risk-return tradeoff available to a mean-variance investor, relative to traditional buy-and-hold strategies. These findings are consistent across the different performance measures employed.

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 to changes in conditioning information.

Number of Pages in PDF File: 48

Keywords: return predictability, asset management

JEL Classification: C12, G11, G12

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Date posted: March 22, 2005  

Suggested Citation

Basu, Devraj and Abhyankar, Abhay and Stremme, Alexander, The Optimal Use of Return Predictability: An Empirical Analysis (March 2005). AFA 2006 Boston Meetings Paper. Available at SSRN: http://ssrn.com/abstract=687083 or http://dx.doi.org/10.2139/ssrn.687083

Contact Information

Devraj Basu
Université Lille Nord de France - Skema Business School ( email )
Campus de Lille
Avenue Willy Brandt, Euralille
Lille, 59777
France
Abhay Abhyankar
University of Exeter Business School, University of Exeter ( email )
Streatham Court
Exeter, EX4 4PU
United Kingdom
Alexander Stremme (Contact Author)
University of Warwick - Finance Group ( email )
Gibbet Hill Rd
Coventry, CV4 7AL
Great Britain
+44 (0) 2476 - 522 066 (Phone)
+44 (0) 2476 - 523 779 (Fax)
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