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Least Squares Predictions and Mean-Variance Analysis

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  • Enrique Sentana

Abstract

We compare the Sharpe ratios of traders who combine one riskless and one risky asset following (i) buy and hold strategies; (ii) timing strategies with forecasts from simple; or (iii) multiple regressions; and (iv) passive allocations of (i) and (ii) with mean-variance optimizers. We show that (iv) implicitly uses the linear forecasting rule that maximizes the Sharpe ratio of managed portfolios, but the remaining rankings are unclear. We also suggest generalized method of moments (GMM) estimators to make (iv) operational and evaluate their significance with spanning tests. Finally, we characterize the equivalence between (iii) and (iv), and propose moment tests to assess it. Copyright 2005, Oxford University Press.

Suggested Citation

  • Enrique Sentana, 2005. "Least Squares Predictions and Mean-Variance Analysis," Journal of Financial Econometrics, Oxford University Press, vol. 3(1), pages 56-78.
    • Handle: RePEc:oup:jfinec:v:3:y:2005:i:1:p:56-78
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    File URL: http://hdl.handle.net/10.1093/jjfinec/nbi002
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    Cited by:

    1. Dante Amengual & Gabriele Fiorentini & Enrique Sentana, 2023. "PML versus minimum $${\chi }^{2}$$ χ 2 : the comeback," SERIEs: Journal of the Spanish Economic Association, Springer;Spanish Economic Association, vol. 14(3), pages 253-300, December.
    2. Patton, Andrew J. & Timmermann, Allan, 2007. "Properties of optimal forecasts under asymmetric loss and nonlinearity," Journal of Econometrics, Elsevier, vol. 140(2), pages 884-918, October.
    3. Xavier Gerard & Ron Guido & Peter Wesselius, 2013. "Integrated alpha modelling," Journal of Asset Management, Palgrave Macmillan, vol. 14(3), pages 140-161, June.
    4. Enrique Sentana, 2009. "The econometrics of mean-variance efficiency tests: a survey," Econometrics Journal, Royal Economic Society, vol. 12(3), pages 65-101, November.
    5. John Y. Campbell & Samuel B. Thompson, 2008. "Predicting Excess Stock Returns Out of Sample: Can Anything Beat the Historical Average?," The Review of Financial Studies, Society for Financial Studies, vol. 21(4), pages 1509-1531, July.
    6. Penaranda, Francisco, 2007. "Portfolio choice beyond the traditional approach," LSE Research Online Documents on Economics 24481, London School of Economics and Political Science, LSE Library.
    7. Davide Pettenuzzo & Francesco Ravazzolo, 2016. "Optimal Portfolio Choice Under Decision‐Based Model Combinations," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 31(7), pages 1312-1332, November.
    8. Peñaranda, Francisco & Sentana, Enrique, 2012. "Spanning tests in return and stochastic discount factor mean–variance frontiers: A unifying approach," Journal of Econometrics, Elsevier, vol. 170(2), pages 303-324.
    9. Dante Amengual & Gabriele Fiorentini & Enrique Sentana, 2022. "PML vs minimum χ 2 : the comeback," Working Papers wp2022_2210, CEMFI.
    10. Timmermann, Allan & Patton, Andrew, 2003. "Properties of Optimal Forecasts," CEPR Discussion Papers 4037, C.E.P.R. Discussion Papers.
    11. René Garcia & Éric Renault & Georges Tsafack, 2007. "Proper Conditioning for Coherent VaR in Portfolio Management," Management Science, INFORMS, vol. 53(3), pages 483-494, March.
    12. Penaranda, Francisco & Sentana, Enrique, 2024. "Portfolio management with big data," CEPR Discussion Papers 19314, C.E.P.R. Discussion Papers.

    More about this item

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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