The prescriptive nature of market timing and predictive portfolios

Abstract

We explore the ability of market timing, model-based forecasts that include incremental information over and above momentum, to create long-short portfolios that consistently provide superior returns to traditional benchmarks, and frame our analysis in the idea of “prediction-led prescription” for forward-looking decision making. Our methodology consists of linear and non-linear forecasts with model selection, that predict the direction of future returns and apply then into the construction of portfolios. Our results strongly recommend that predictive-based portfolio allocation can produce excess returns and higher Sharpe ratios, above and beyond the individual return series that are utilized to create the forecasts and traditional portfolio benchmarks. The use of “predictive methods in portfolio construction reinforces the idea of prediction-led prescription” as portfolios are prescriptions for investment management and have an exclusively forward-looking nature.