Time-Varying Sharpe Ratios and Market Timing

30 Pages Posted: 6 Oct 2011

See all articles by Yi Tang

Yi Tang

Fordham University - Gabelli School of Business

Robert Whitelaw

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

Multiple version iconThere are 2 versions of this paper

Date Written: August 31, 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 forecast-ability of returns, it is the latter factor that accounts primarily for both the in-sample and out-of-sample results.

Keywords: Sharpe ratio, predictability, stock market

JEL Classification: G11, G12

Suggested Citation

Tang, Yi and Whitelaw, Robert F., Time-Varying Sharpe Ratios and Market Timing (August 31, 2011). Available at SSRN: https://ssrn.com/abstract=1938613 or http://dx.doi.org/10.2139/ssrn.1938613

Yi Tang

Fordham University - Gabelli School of Business ( email )

113 West 60th Street
New York, NY 10023
United States

Robert F. Whitelaw (Contact Author)

New York University ( email )

Stern School of Business
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New York, NY 10012-1126
United States
212-998-0338 (Phone)
212-995-4233 (Fax)

National Bureau of Economic Research (NBER)

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United States

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