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Return Forecasts Good Enough for Mean-variance Optimization?

November 3, 2017 • Posted in Fundamental Valuation, Strategic Allocation

Are there stock return forecasts good enough to make mean-variance optimization work as a stock portfolio allocation strategy? In their October 2017 paper entitled “Mean-Variance Optimization Using Forward-Looking Return Estimates”, Patrick Bielstein and Matthias Hanauer test whether firm implied cost of capital (ICC) based on analyst earnings forecasts is effective as a stock return forecast for mean-variance portfolio optimization. They derive ICC annually for each stock as the internal rate of return (discount rate) implied by a valuation model that equates forecasted cash flows, derived from analyst earnings forecasts, to market valuation. To refine ICC estimates, they correct predictable analyst forecast errors (slow reactions to news) by including a standardized, rescaled momentum variable based on return from 12 months ago to one month ago (ICCadj). They then employ ICCadj to specify annual (each June 30) mean-variance optimized (maximum Sharpe ratio) long-only stock allocations (with maximum weight 5%) based on stock return covariances calculated from returns over the last 60 months. For benchmarks, they consider the value-weighted market portfolio (VW), the equal-weighted market portfolio (EW), the minimum variance portfolio (MVP) and a maximum Sharpe ratio portfolio based on 5-year moving average actual returns (HIST). They focus on U.S. stocks, which have relatively broad analyst coverage. They test robustness of findings with data from selected international developed markets, different return variable specifications, different subperiods and impact of transaction costs. Using monthly data for the 1,000 U.S. common stocks with the biggest prior-month market capitalizations since June 1985 and the 250 biggest stocks in each of Europe, UK and Japan since 1990, all through June 2015, they find that:


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