40 Pages Posted: 8 Apr 2011
Date Written: April 15, 2008
Using data for the S&P 500 Sector portfolios between 1989 and 2007, I find that sample-based mean-variance portfolios are very unstable and perform poorly out of sample in terms of Sharpe ratios, certainty equivalent returns and turnover. Minimum-variance and Bayes-Stein portfolios, which are supposed to be less susceptible to the estimation error plaguing mean-variance, also fall significantly short of a naive equally-weighted policy. Imposing shortsale or turnover constraints limits the fluctuation of portfolio weights and improves performance considerably. When the normality assumption about excess portfolio returns is relaxed, there is no evidence of the constrained portfolios performing worse than the exulted equally-weighted portfolio. I propose a sophisticated turnover constraint rule which recognizes the path dependency of the optimal portfolio policy and enhances the out-of-sample monthly Sharpe ratio by 13% relative to the best of the other strategies considered in this paper.
Keywords: portfolio allocation, out-of-sample performance, turnover constraints
JEL Classification: G11
Suggested Citation: Suggested Citation