Optimized Fundamental Portfolios
Equity portfolio construction consists of two stages: generating beliefs about the future performance of available stocks and allocating wealth across the stocks to maximize the expected return subject to a specified risk tolerance. Two streams of prior research have addressed each portfolio construction stage independently. Fundamental analysis aids in the first stage by identifying accounting ratios that predict future stock returns, but provides little insight with respect to creating portfolios. Portfolio optimization aids in the second stage by determining weights to place on stocks to build a portfolio that maximizes expected returns subject to a specified risk tolerance, but there is little empirical evidence suggesting that it is helpful to investors. We use a fundamentals-based returns model in conjunction with classic mean-variance portfolio optimization and find that portfolio optimization combined with fundamental analysis offers substantial improvements in portfolio performance over either fundamental analysis or portfolio optimization alone. Long-only mean-variance optimized fundamental portfolios produce CAPM alphas of over 3.2% per quarter and 5-factor alphas of over 2.2% per quarter, with high Sharpe and Information ratios. The relative gains to investors from combining fundamental analysis with portfolio optimization are even more pronounced when small capitalization firms are eliminated from the investment set.