A Method for Return Enhancement
15 Pages Posted: 17 Jan 2007
Date Written: December 2006
Abstract
Stock returns depend on attributes such as size, book to market, and prior returns. The paper observes that since these attributes change randomly over time, the standard unconditional mean variance approach to portfolio optimization does not distinguish between returns with different attributes. The paper shows that removing this inefficiency by applying the optimization procedure to a set of portfolios each containing only stocks that are ranked the same on a given attribute produces portfolios with gigantic level of ex ante Sharpe ratio. For example, testing this method for monthly data of portfolios ranked on size and book to market or momentum implies (annualized) ex ante Sharpe Ratios of over two in the last twenty five years. This is four times larger than the Sharp Ratio of a standard market proxy.
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