By S. P. Kothari
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Extra resources for Anomalies and Efficient Portfolio Formation
By an argument similar to that for alpha and residual risk, uncertainty about the market’s true mean return increases the (predictive) risk perceived by the investor and lowers the perceived market Sharpe ratio. Other things being equal, this market effect tends to increase the optimal weight on the tilt portfolio. Recall from our earlier analysis of the BV/MV anomaly that when we ignore parameter uncertainty and assume no short selling, being fully invested in the high-BV/MV quintile is optimal.
The Q5–Q1 spread results for BV/MV in Table 3 are notable in several respects, and we found similar results whether we imposed the small/low price filter or not. First, the optimal portfolio is invested nearly 40 percent in the spread, with the percentage dropping to about 30 when alpha was cut in half. 4 percent), and the spread beta is negative; the high-BV/MV quintile has a significantly lower beta than the lowBV/MV quintile. 4 percent alpha at the 100 percent level, might seem odd, but the pattern is mechanically driven by the fact that the spread return is lower than the market return.
Almost half of the optimal portfolio was then invested in the market index, with about a quarter each in the value and momentum spreads. That value and momentum should play an important role in optimal portfolio decisions is to be expected, given the literature on CAPM anomalies. The extent to which aggressive investment in these anomalies seems to be called for, even with substantial reductions in alphas and the incorporation of Bayesian estimation risk, is more unexpected. book Page 47 Thursday, December 19, 2002 11:51 AM Anomalies and Efficient Portfolio Formation We hope to have provided insights into the risk and return characteristics of anomaly-based investment strategies that will be useful to investors in making future portfolio decisions.
Anomalies and Efficient Portfolio Formation by S. P. Kothari