Sharpe performance in Table 3 where this strategy has a negative Sharpe
The abnormal returns of the four strategies in panel A are highly statistically
signiﬁcant and economically large. The strategy that uses the CAPM model has
the lowest abnormal returns across the four strategies, because this strategy has
a lower mean excess return compared to the other three strategies. All four
strategies have a negative beta on the FTA index when performance is
estimated using the Jensen measure. The strategy that uses the APT model has
the highest performance with the Jensen measure and the FF model has the
highest performance with the FS measure.
When investors face binding investment constraints as in panel B of Table 5,
all four strategies still deliver a higher Sharpe performance than either the FTA
market index or the strategy that uses the characteristics model. The
performance across the four strategies manifests less variation compared to that
in panel A. High mean excess returns and low standard deviation characterize
all four strategies. The smaller means leads to lower abnormal returns in panel
B compared to those in panel A. However the Jensen and FS performance of
the four strategies are still highly signiﬁcantly positive and economically large.
The strategies that use the EGB and FF models exhibit the highest positive
performance across the four strategies.
The evidence in Table 5 suggests that strategies which use linear asset
pricing models to forecast expected excess returns are able to signiﬁcantly
outperform alternative passive strategies whenever conditional versions of the
models are used. Furthermore the strategies which rely on linear asset pricing
models are able to outperform the strategy that uses the characteristics model
in terms of higher Sharpe performance and more positive abnormal returns.
These ﬁndings support the evidence in Jagannathan and Wang (1996), Hodrick
and Zhang (2001), and Lettau and Ludvigson (2001) among others that
conditional asset pricing models are more able to explain the cross-section of
This paper examines the out of sample performance of domestic asset
allocation strategies in U.K. stock returns between February 1981 and April
2000 where linear asset pricing models and a characteristics model of stock
returns are used to forecast expected excess returns. Our ﬁndings suggest that
when unconditional versions of asset pricing models are used, the performance
of the strategies that use multifactor asset pricing models is poor. However this
all changes when we use conditional versions of the asset pricing models.
267Characteristics Versus Covariances