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It’s All in the Timing: Simple Active Portfolio Strategies that Outperform Naïve Diversification

Published online by Cambridge University Press:  20 January 2012

Chris Kirby  and
Barbara Ostdiek
Chris Kirby
Affiliation:
Belk College of Business, University of North Carolina at Charlotte, 9201 University City Blvd., Charlotte, NC 28223. [email protected]
Barbara Ostdiek
Affiliation:
Jones Graduate School of Business, Rice University, PO Box 2932, Houston, TX 77252. [email protected]
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Abstract

DeMiguel, Garlappi, and Uppal (2009) report that naïve diversification dominates mean-variance optimization in out-of-sample asset allocation tests. Our analysis suggests that this is largely due to their research design, which focuses on portfolios that are subject to high estimation risk and extreme turnover. We find that mean-variance optimization often outperforms naïve diversification, but turnover can erode its advantage in the presence of transaction costs. To address this issue, we develop 2 new methods of mean-variance portfolio selection (volatility timing and reward-to-risk timing) that deliver portfolios characterized by low turnover. These timing strategies outperform naïve diversification even in the presence of high transaction costs.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 47 , Issue 2 , April 2012 , pp. 437 - 467
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2012

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