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Journal of Financial Econometrics 2005 3(1):56-78; doi:10.1093/jjfinec/nbi002
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Journal of Financial Econometrics, Vol. 3, No. 1, © Oxford University Press 2005; all rights reserved.

Least Squares Predictions and Mean-Variance Analysis

Enrique Sentana
     CEMFI, CEPR, and LSE FMG

Address correspondence to Enrique Sentana, Casado del Alisal 5, 28014 Madrid, Spain, or e-mail: sentana{at}cemfi.es.

We compare the Sharpe ratios of traders who combine one riskless and one risky asset following (i) buy and hold strategies; (ii) timing strategies with forecasts from simple; or (iii) multiple regressions; and (iv) passive allocations of (i) and (ii) with mean-variance optimizers. We show that (iv) implicitly uses the linear forecasting rule that maximizes the Sharpe ratio of managed portfolios, but the remaining rankings are unclear. We also suggest generalized method of moments (GMM) estimators to make (iv) operational and evaluate their significance with spanning tests. Finally, we characterize the equivalence between (iii) and (iv), and propose moment tests to assess it.

KEYWORDS: delegated portofolio management, financial forecasting, portfolio performance evaluation, Sharpe ratios, spanning tests

Received March 1, 2004; revised October 14, 2004; accepted October 21, 2004


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