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Least Squares Predictions and Mean-Variance Analysis

  • Enrique Sentana

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.

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File URL: http://hdl.handle.net/10.1093/jjfinec/nbi002
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Article provided by Society for Financial Econometrics in its journal Journal of Financial Econometrics.

Volume (Year): 3 (2005)
Issue (Month): 1 ()
Pages: 56-78

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Handle: RePEc:oup:jfinec:v:3:y:2005:i:1:p:56-78
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  1. Admati, Anat R & Pfleiderer, Paul, 1990. "Direct and Indirect Sale of Information," Econometrica, Econometric Society, vol. 58(4), pages 901-28, July.
  2. Arellano, Manuel, 1989. "On the efficient estimation of simultaneous equations with covariance restrictions," Journal of Econometrics, Elsevier, vol. 42(2), pages 247-265, October.
  3. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, vol. 55(3), pages 587-613, May.
  4. Peter J. Knez & Zhiwu Chen, 1998. "Portfolio Performance Measurement: Theory and Applications," Yale School of Management Working Papers ysm48, Yale School of Management.
  5. Grossman, Sanford J & Stiglitz, Joseph E, 1980. "On the Impossibility of Informationally Efficient Markets," American Economic Review, American Economic Association, vol. 70(3), pages 393-408, June.
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