Highlights

  • Mean-variance optimization (MVO) is an effective portfolio construction tool widely used by practitioners, but it can be highly sensitive to inputs such as expected returns and asset correlations.
  • One alternative is to weight each portfolio asset by its Sharpe ratio – its return per unit of risk – which can be simpler to implement.
  • In theory, an asset’s expected return is proportional to its risk, which should result in an equally weighted portfolio when using an unconstrained Sharpe-weighting approach to portfolio construction.
  • In practice, however, assets exhibit different relative risk-return profiles over time, which opens up the possibility of using Sharpe ratio as a tactical asset allocation tool.
  • This research explores historical Sharpe ratios of selected equity and fixed income asset classes and tests the efficacy of a Sharpe-weighted allocation approach under various scenarios.

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