The Optimal Use of Return Predictability: An Empirical Analysis

45 Pages Posted: 2 Mar 2005

See all articles by Abhay Abhyankar

Abhay Abhyankar

University of Exeter Business School, University of Exeter

Devraj Basu

SKEMA Business School - Lille Campus

Alexander Stremme

University of Warwick - Finance Group

Date Written: February 28, 2005

Abstract

In this paper we investigate the empirical performance of unconditionally efficient portfolios strategies for a number of commonly used predictive variables. These strategies, which optimally utilize asset return predictability in portfolio formation were studied by Hansen and Richard (1987) and Ferson and Siegel (2001). Our criterion is to maximize various ex-post performance measures and we conduct both in-sample as well as out-of-sample analysis. Our analysis allows us to determine the economic value of using different predictor variables and also groups of predictor variables.

Overall we find that the optimal use of conditioning information significantly improves the risk-return tradeoff available to a mean-variance investor relative to fixed weight strategies. These findings are consistent across portfolio efficiency measures such as Sharpe ratios, portfolio variance subject to a mean constraint or portfolio mean subject to a volatility constraint as well as measures of economic value such as switching costs.

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 of the two strategies to conditioning information.

Keywords: Asset pricing, return predictability

JEL Classification: C12, G11, G12

Suggested Citation

Abhyankar, Abhay and Basu, Devraj and Stremme, Alexander, The Optimal Use of Return Predictability: An Empirical Analysis (February 28, 2005). EFA 2005 Moscow Meetings Paper; Cass Business School Research Paper. Available at SSRN: https://ssrn.com/abstract=677009 or http://dx.doi.org/10.2139/ssrn.677009

Abhay Abhyankar

University of Exeter Business School, University of Exeter ( email )

Streatham Court
Exeter, EX4 4PU
United Kingdom

Devraj Basu

SKEMA Business School - Lille Campus ( email )

Avenue Willy Brandt, Euralille
Lille, 59777
France

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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