Dynamic Strategies, Asset Pricing Models, and the Out-of-Sample Performance of the Tangency Portfolio

Cesare Robotti
Working Paper 2003-6
February 2003

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In this paper, I study the behavior of an investor with unit risk aversion who maximizes a utility function defined over the mean and the variance of a portfolio’s return. Conditioning information is accessible without cost and an unconditionally riskless asset is available in the market.

The proposed approach makes it possible to compare the performance of a benchmark tangency portfolio (formed from the set of unrestricted estimates of portfolio weights) to the performance of a restricted tangency portfolio which uses single-index and multi-index asset pricing models to constrain the first moments of asset returns.

The main findings of the paper are summarized as follows: i) The estimates of the constant and time-varying tangency portfolio weights are extremely volatile and imprecise. Using an asset pricing model to constrain mean asset returns eliminates extreme short positions in the underlying securities and improves the precision of the estimates of the weights. ii) Partially restricting mean asset returns according to single-index and multi-index asset pricing models improves the out-of-sample performance of the tangency portfolio. iii) Active investment strategies (i.e., strategies that incorporate the role played by conditioning information in investment decisions) strongly dominate passive investment strategies in-sample but do not provide any convincing pattern of improved out-of-sample performance.

JEL classification: G11, G12, G15

Keywords: asset allocation, conditioning information, dynamic strategies, tangency portfolio

The author gratefully acknowledges Pierluigi Balduzzi for his invaluable advice, suggestions, and encouragement. He is also indebted to Arthur Lewbel, Eric Jacquier, Alan Marcus, Raymond Kan, Tongshu Ma, Craig MacKinlay, Richard Priestley, Allexander Philipov, Paula Tkac, Gerald Dwyer, an anonymous referee, and Anna Krivelyova for many helpful comments. Suggestions from seminar participants at the 2001 meetings of the Western Finance Association, Boston College, University of Toronto, University of California at Irvine, Stockholm School of Economics, Norwegian School of Management BI, L. Bocconi University, Federal Reserve Bank of Atlanta and Nanyang Technological University are also acknowledged. Previous versions of this paper were presented at the ITG and AlphaSimplex weekly workshops. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to Cesare Robotti, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree Street, N.E., Atlanta, Georgia 30309-4470, 404-498-8543, cesare.robotti@atl.frb.org.