Optimized Fundamental Portfolios

49 Pages Posted: 27 Dec 2018 Last revised: 11 Jan 2019

Date Written: December 13, 2018

Abstract

Equity portfolio construction consists of two stages: generating beliefs about the future performance of available stocks and allocating wealth across the stocks to maximize the expected return subject to a specified risk tolerance. Two streams of prior research have addressed each portfolio construction stage independently. Fundamental analysis aids in the first stage by identifying accounting ratios that predict future stock returns, but provides little insight with respect to creating portfolios. Portfolio optimization aids in the second stage by determining weights to place on stocks to build a portfolio that maximizes expected returns subject to a specified risk tolerance, but there is little empirical evidence suggesting that it is helpful to investors. We use a fundamentals-based returns model in conjunction with classic mean-variance portfolio optimization and find that portfolio optimization combined with fundamental analysis offers substantial improvements in portfolio performance over either fundamental analysis or portfolio optimization alone. Long-only mean-variance optimized fundamental portfolios produce CAPM alphas of over 3.2% per quarter and 5-factor alphas of over 2.2% per quarter, with high Sharpe and Information ratios. The relative gains to investors from combining fundamental analysis with portfolio optimization are even more pronounced when small capitalization firms are eliminated from the investment set.

Keywords: Fundamental Analysis, Portfolio Optimization, Return Prediction, Accounting-Based Valuation

JEL Classification: G11, G12, G14, M41

Suggested Citation

Lyle, Matthew R. and Yohn, Teri Lombardi, Optimized Fundamental Portfolios (December 13, 2018). Kelley School of Business Research Paper No. 19-8. Available at SSRN: https://ssrn.com/abstract=3300976 or http://dx.doi.org/10.2139/ssrn.3300976

Matthew R. Lyle (Contact Author)

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Teri Lombardi Yohn

Indiana University - Kelley School of Business - Department of Accounting ( email )

1309 E. 10th Street
Bloomington, IN 47405
United States
(812) 855-0430 (Phone)

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