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Characteristic-based mean-variance portfolio choice

  • Hjalmarsson, Erik
  • Manchev, Petar

We study empirical mean-variance optimization when the portfolio weights are restricted to be direct functions of underlying stock characteristics such as value and momentum. The closed-form solution to the portfolio weights estimator shows that the portfolio problem in this case reduces to a mean-variance analysis of assets with returns given by single-characteristic strategies (e.g., momentum or value). In an empirical application to international stock return indexes, we show that the direct approach to estimating portfolio weights clearly beats a naive regression-based approach that models the conditional mean. However, a portfolio based on equal weights of the single-characteristic strategies performs about as well, and sometimes better, than the direct estimation approach, highlighting again the difficulties in beating the equal-weighted case in mean-variance analysis. The empirical results also highlight the potential for ‘stock-picking’ in international indexes using characteristics such as value and momentum with the characteristic-based portfolios obtaining Sharpe ratios approximately three times larger than the world market.

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Article provided by Elsevier in its journal Journal of Banking & Finance.

Volume (Year): 36 (2012)
Issue (Month): 5 ()
Pages: 1392-1401

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Handle: RePEc:eee:jbfina:v:36:y:2012:i:5:p:1392-1401
Contact details of provider: Web page: http://www.elsevier.com/locate/jbf

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