The Importance of Accounting Information in Portfolio Optimization

We study the economic importance of accounting information as defined by the value that sophisticated investors can extract from financial statements when maximizing their expected utility from holding a portfolio of U.S. equities. Our approach applies the elegant parametric portfolio policy (PPP) method of Brandt, Santa-Clara and Valkanov (2009) that models portfolio weights as a linear function of firm-specific characteristics. We find that three illustrative accounting-based characteristics—accruals, change in earnings, and asset growth—are economically important in that the set of optimal portfolio weights they generate yield an out-ofsample, pre-transactions-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 pre-transactions-costs delevered hedge portion of the accounting-based optimal portfolio was especially valuable during two recent shocks. First, it earned 12% during 2008 as compared to 3% for the price-based hedge and –38% for the value-weighted market. Second, it fared far better than the price-based hedge during the Quant Meltdown of August, 2007. This draft: Oct. 13, 2009 We appreciate the comments of workshop participants at UNC Chapel Hill and the 2009 JAAF Conference. We are also very grateful to Michael Brandt, Pedro Santa-Clara and Ross Valkanov for sharing important parts of their MATLAB code with us.