A shrinkage approach for Sharpe ratio optimal portfolios with estimation risks

We consider the problem of maximizing the out-of-sample Sharpe ratio when portfolio weights have to be estimated. We apply an improved bootstrap-based estimator, and an approximative estimator derived from a Taylor series. In a simulation study and empirical analysis with 15 datasets the proposed estimators outperform the minimum variance and equally weighted portfolio strategies. Out-of-sample Sharpe ratios improve by 15 and 32 percent on average, respectively, in the empirical analysis. While effectively dealing with estimation risks, the estimators produce considerable amounts of turnover. Realized net Sharpe ratios improve by 40 percent on average when the effects of accruing transaction costs are incorporated ex-ante into estimation of portfolio weights. When adding a risk-free asset, net Sharpe ratios remain of the same magnitude and portfolio volatility does not exceed a predefined target level.