The Importance of Accounting Information in Portfolio Optimization

Abstract

We study the economic importance of accounting information as defined by the value that a sophisticated investor can extract from publicly available financial statements when optimizing a portfolio of U.S. equities. Our approach applies the elegant new parametric portfolio policy method of Brandt, Santa-Clara, and Valkanov (2009) to three simple and firm-specific annual accounting characteristics-accruals, change in earnings, and asset growth. We find that the set of optimal portfolio weights generated by accounting characteristics yield an out-of-sample, pre-transact ions-costs annual information ratio of 1.9 as compared to 1.5 for the standard price-based characteristics of firm size, book-to-market, and momentum. We also find that the delevered hedge portion of the accounting-based optimal portfolio was especially valuable during the severe bear market of 2008 because unlike many hedge finds it delivered a hedged return in 2008 of 12 percent versus only 3 percent for price-based strategies and −38 percent for the value-weighted market.