Monday, February 1, 2016

name of this portfolio optimization strategy


I have come across a portfolio selection strategy that buys in equal amounts the top decile of expected earners, and simultaneously short sells the lowest decile in a similar fashion. What is this strategy called? I am looking for words more specific than "market/dollar neutral."



Answer



Short answer: This 'portfolio sort' is rather a common approach in empirical finance research, than a portfolio strategy.




Your mentioned strategy is called 'portfolio analysis' or in more detail a 'univariat portfolio sort'. The general approach is to form portfolios of stocks, where the stocks in each portfolio have different levels of the variable posited to analyze cross-sectional relations. As a nonparametric technique, it does not make any assumptions about the nature of the cross-sectional relations between the variables under investigation.


The steps are as follows:




  1. Calculate periodic (e.g. yearly) breakpoints that will be used to group the entities in the sample into portfolios. The breakpoints are usually determined by percentiles of the sort-variable $X$ at time $t$ of the cross-sectional distribution.

  2. Group all entities in the sample into portfolios. Each time period $t$, all entities in the sample with values of $X$ that are less than or equal to he first breakpoint are put in portfolio one, i.e. the 'low' portfolio. Portfolio two holds entities with values of $X$ that are greater than er equal to the first and less than or equal to the second breakpoint, and so on.

  3. Calculate the equal- or value-weighted return for each portfolio for the subsequent year.

  4. In addition to calculating the average return for each portfolio, you often calculate the return-difference of the high- and low-portfolio, that is a strategy investing long in the highest and short in the lowest portfolio. This difference portfolio is the primary value used to detect a cross-sectional relation between the sort variable and the outcome variable (here: return).




It is common practice, to update the portfolios yearly. If you sort on the 'momentum' variable, monthly reformation is common. For example, Fama/French (1992) form portfolios based on size or book-to-market ratio at the end of June each year and calculate the return for the subsequent year. The formation at the end of June is due to the 'look-ahead-bias', that is to avoid to use accounting data for the previous fiscal-year end, which may not be publicly available until end June of the next year.


Be aware to try exploiting this strategy:





  • Portfolio reformation results in high transaction costs, which may decrease the return significantly.




  • Due to regularization it is often not possible to fully replicate the short-strategy.






References:


Bali/Engle/Murray (2016), Empirical Asset Pricing: The cross-section of stock returns, 1. ed.


Fama/French (1992), The cross-section of expected stock returns, The Journal of Finance.



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