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Botshekan, Mahmoud
Lucas, Andre
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Tinbergen Institute Discussion Paper 12-053/2/DSF34
We determine the importance of long-term and short-term components of state variables for asset allocation decisions. The long-term and short-term decompositions are performed using a variety of filtering techniques. We allow for a flexible semiparametric form of the dependence of asset allocation decisions on state variable components. To account for short-sale restrictions, we extend the regular GMM moment conditions with the appropriate Lagrange-Kuhn-Tucker multipliers. Empirically, we find that investors can benefit from reacting differently to short-term versus long-term dynamics of state variables. The induced allocation decisions are implemented in an investment backtest. We find significant improvements in terms of out-of-sample Sharpe ratios and expected utilities for state variables such as the dividend yield and stock market trend.
Portfolio choice
long and short-term asset allocation
trend-cycle decomposition
GMM under short-sale constraints
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Working Paper

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