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Characteristic-based mean-variance portfolio choice

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  • Erik Hjalmarsson
  • Peter Manchev

Abstract

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.

Suggested Citation

  • Erik Hjalmarsson & Peter Manchev, 2009. "Characteristic-based mean-variance portfolio choice," International Finance Discussion Papers 981, Board of Governors of the Federal Reserve System (U.S.).
  • Handle: RePEc:fip:fedgif:981
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    References listed on IDEAS

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    Cited by:

    1. Chia, Rui Ming Daryl & Lim, Kai Jie Shawn, 2012. "The Attenuation of Idiosyncratic Risk under Alternative Portfolio Weighting Strategies: Recent Evidence from the UK Equity Market," MPRA Paper 41455, University Library of Munich, Germany.
    2. Ammann, Manuel & Coqueret, Guillaume & Schade, Jan-Philip, 2016. "Characteristics-based portfolio choice with leverage constraints," Journal of Banking & Finance, Elsevier, vol. 70(C), pages 23-37.
    3. Xia, Hui & Min, Xinyu & Deng, Shijie, 2015. "Effectiveness of earnings forecasts in efficient global portfolio construction," International Journal of Forecasting, Elsevier, vol. 31(2), pages 568-574.
    4. Ardia, David & Boudt, Kris & Wauters, Marjan, 2016. "The economic benefits of market timing the style allocation of characteristic-based portfolios," The North American Journal of Economics and Finance, Elsevier, vol. 37(C), pages 38-62.

    More about this item

    Keywords

    Portfolio management;

    JEL classification:

    • C22 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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