22 stocks of major liquid companies were selected from different economic sectors of the USA to demonstrate an example of a strategy and have no intention of providing any investment recommendation. Further analysis is based on monthly close prices recorded over the past 4 years (50 months). Using the approaches of modern portfolio theory and the method of portfolio analysis (http://www.ifcmarkets.com/
Maximization of return was chosen as an optimality criterion of the investment strategy, subject to the portfolio’s risk does not exceed the average risk level of its components. In other words, the standard deviation of portfolio’s returns should not exceed the average standard deviations of the 22 stocks (equal to 6.40%). Optimization of the portfolio’s structure (http://www.ifcmarkets.com/
To demonstrate the difference between the two structural elements of the strategy, the lists of longs and shorts, charts of the absolute value of each of them were constructed with the help of GeWorko method. Chart 1 illustrates performance of the portfolio consisting only of the assets from the list of longs. This portfolio experienced a significant fall in 2008, but since the beginning of January 2009 its value increased by 2.5 times.
Chart 2 similarly reflects the absolute total value of the assets from the list of shorts, and although the strategy involves the sale of these assets, for comparison purposes a hypothetical purchase of such a portfolio is presented here. It is obvious that the assets which got negative weights in the optimization have significantly underperformed the portfolio of longs, as evidenced by a three-fold reduction in their total value in 2008 and the following modest growth.
But what happens when the two portfolios are combined in the framework of a single investment strategy? In the new combined portfolio both longs and shorts with the corresponding weights obtained during optimization are included. In other words, the purchase of the portfolio of longs takes place simultaneously with the sale of the portfolio of shorts. Chart 3 is obtained with the help of GeWorko method to assess the effectiveness of the strategy.
It is clear that the growing structure of the combined portfolio has avoided any significant fall in 2008 and showed a substantially continuous, smooth and steady growth in the post-crisis period. This means that the increase in value of the portfolio of longs in recent years has been systematically exceeding the growth of the portfolio of shorts. The realized monthly return of this strategy amounted to 7.52% and due to the inclusion of short positions was much higher than individual realized return of any of the 22 assets which not exceeded 3.32%.
GeWorko method allowed revealing differences in the performance of two sets of assets and implementing this idea in the form of a trading strategy. Thanks to the combination of long and short positions the strategy has been remaining profitable for several years. Potential gain from diversification can be significantly increased by adding various classes of assets in the portfolio. It is even difficult to imagine what opportunities for multi-profile analysis of markets and trading with GeWorko method can arise in this case.