Abstract
This paper features an analysis of the effectiveness of a range of portfolio diversification strategies, with a focus on down-side risk metrics, as a portfolio diversification strategy in a European market context. We apply these measures to a set of daily arithmetically-compounded returns, in U.S. dollar terms, on a set of ten market indices representing the major European markets for a nine-year period from the beginning of 2005 to the end of 2013. The sample period, which incorporates the periods of both the Global Financial Crisis (GFC) and the subsequent European Debt Crisis (EDC), is a challenging one for the application of portfolio investment strategies. The analysis is undertaken via the examination of multiple investment strategies and a variety of hold-out periods and backtests. We commence by using four two-year estimation periods and a subsequent one-year investment hold out period, to analyse a naive 1/N diversification strategy and to contrast its effectiveness with Markowitz mean variance analysis with positive weights. Markowitz optimisation is then compared to various down-side investment optimisation strategies. We begin by comparing Markowitz with CVaR, and then proceed to evaluate the relative effectiveness of Markowitz with various draw-down strategies, utilising a series of backtests. Our results suggest that none of the more sophisticated optimisation strategies appear to dominate naive diversification.
Highlights
It is some sixty years since Markowitz [1] developed portfolio theory. It became a central foundation of classical finance, leading directly to the development of the capital asset pricing model (CAPM) by Sharpe [2], Lintner [3], Mossin [4] and Treynor [5], its practical application has been surrounded by difficulties
With mean-variance analysis, plus other portfolio optimisation techniques, such as the optimisation of conditional value at risk (CVaR), and other techniques, such as various draw-down strategies, and our analysis is conducted across the major European equity markets
We have examined the effectiveness of a variety of portfolio optimisation strategies, for a sample of ten major European market indices over a recent nine-year period terminating at the end of 2013
Summary
It is some sixty years since Markowitz [1] developed portfolio theory. It became a central foundation of classical finance, leading directly to the development of the capital asset pricing model (CAPM) by Sharpe [2], Lintner [3], Mossin [4] and Treynor [5], its practical application has been surrounded by difficulties. 206) states that: “Problems concerning the proper information to serve as the basic inputs concerning securities are outside the scope of this monograph. There are no magic formulas to supplant the sources of information and the rules of judgement of the security analyst”
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