Mean-Variance Optimization vs. Equal Weight for Sectors and Individual Stocks

Are mean-variance (MV) strategies preferable for allocations to asset classes and equal-weight (EW) preferable for allocations to much noisier individual assets? In their May 2019 paper entitled “Horses for Courses: Mean-Variance for Asset Allocation and 1/N for Stock Selection”, Emmanouil Platanakis, Charles Sutcliffe and Xiaoxia Ye address this question. They focus on the Bayes-Stein shrinkage MV strategy, with 10 U.S. equity sector indexes as asset classes and the 10 stocks with the largest initial market capitalizations within each sector (except only three for telecommunications) as individual assets. The Bayes–Stein shrinkage approach dampens the typically large effects of return estimation errors on MV allocations. For estimation of MV return and return covariance inputs, they use an expanding (inception-to-date) 12-month historical window. They focus on one-month-ahead performances of portfolios formed in four ways via a 2-stage process:

1. MV-EW, which uses MV to determine sector allocations and EW to determine stock allocations within sectors.
2. EW-EW, which uses EW for both deteriminations.
3. EW-MV, which uses EW to determine sector allocations and MV to determine stock allocations within sectors.
4. MV-MV, which uses MV for both deteriminations.

They consider four net performance metrics: annualized certainty equivalent return (CER) gain for moderately risk-averse investors; annualized Sharpe ratio (reward for risk); Omega ratio (average gain to average loss); and, Dowd ratio (reward for value at risk). They assume constant trading frictions of 0.5% of value traded. They perform robustness tests for U.S. data by using alternative MV strategies, different parameter settings and simulations. They perform a global robustness test using value-weighted equity indexes for UK, U.S., Germany, Switzerland, France, Canada and Brazil as asset classes and the 10 stocks with the largest initial market capitalizations within each index as individual assets (all in U.S. dollars). Using monthly total returns for asset classes and individual assets as specified and 1-month U.S. Treasury bill yield as the risk-free rate during January 1994 through August 2017, they find that: (more…)