Time-Varying Sharpe Ratios and Market Timing

30 Pages Posted: 11 Nov 2008

See all articles by Robert Whitelaw

Robert Whitelaw

New York University; National Bureau of Economic Research (NBER)

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Date Written: September 2011

Abstract

This paper documents predictable time-variation in stock market Sharpe ratios. Predetermined financial variables are used to estimate both the conditional mean and volatility of equity returns, and these moments are combined to estimate the conditional Sharpe ratio, or the Sharpe ratio is estimated directly as a linear function of these same variables. In sample, estimated conditional Sharpe ratios show substantial time-variation that coincides with the phases of the business cycle. Generally, Sharpe ratios are low at the peak of the cycle and high at the trough. In an out-of-sample analysis, using 10-year rolling regressions, relatively naive market-timing strategies that exploit this predictability can identify periods with Sharpe ratios more than 45% larger than the full sample value. In spite of the well-known predictability of volatility and the more controversial forecastability of returns, it is the latter factor that accounts primarily for both the in-sample and out-of-sample results.

Suggested Citation

Whitelaw, Robert F., Time-Varying Sharpe Ratios and Market Timing (September 2011). NYU Working Paper No. 2451/29951. Available at SSRN: https://ssrn.com/abstract=1298278

Robert F. Whitelaw (Contact Author)

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