Higher Sharpe Ratios Research Articles

Reuters Sentiment and Stock Returns

Sentiment from more than 3.6 million Reuters news articles is tested in a vector autoregression model framework on its ability to forecast returns of the Dow Jones Industrial Average stock index. We show that Reuters sentiment can explain and predict changes in stock returns better than macroeconomic factors. We further find that negative Reuters sentiment has more predictive power than positive Reuters sentiment. Trading strategies with Reuters sentiment achieve significant outperformance with high success rates as well as high Sharpe ratios.

Equity Allocation Without Estimation Risk

We jointly control the ill-behaviour of mean-variance weights and outperform 1/N’th investing with two equity allocation methods that moderate or eliminate the adverse impact of estimation-risk on portfolio weights. Normalized systematic to unsystematic-risk weight portfolios moderate estimation-risk. Ex-ante excess-return weight portfolios eliminate estimation-risk and have the highest Sharpe ratio above the 1/N’th strategy. We find high Sharpe ratios in industry-rotation with high-return industries and in security-selection with high-return common shares that we identify with Blazenko and Fu’s (2013) ex-ante returns without explicit risk analysis and without estimation.

The Carry Trade: Risks and Drawdowns

We find important differences in dollar-based and dollar-neutral G10 carry trades. Dollar-neutral trades have positive average returns, are highly negatively skewed, are correlated with risk factors, and exhibit considerable downside risk. In contrast, a diversified dollar-carry portfolio has a higher average excess return, a higher Sharpe ratio, minimal skewness, is uncorrelated with standard risk-factors, and exhibits no downside risk. Distributions of drawdowns and maximum losses from daily data indicate a role for time-varying autocorrelation in determining negative skewness at longer horizons.

Rethinking Portfolio Rebalancing: IntroducingRisk Contribution Rebalancing as anAlternative Approach to TraditionalValue-Based Rebalancing Strategies

The authors propose a new approach to portfolio rebalancing: by decomposing the investor’s strategic asset allocation into the various asset classes’ percentage contributions to risk. Instead of the asset classes’ commonly used value weights, a practitioner would apply this set of risk contributions to controlling rebalancing procedures during the investment phase. In strong contrast to traditional value-based rebalancing strategies, the resulting risk contribution strategies are capable of triggering rebalancing procedures, based on deviations in an asset class’s standalone volatility or correlation to the portfolio’s remaining asset classes. Thus, this method lets practitioners closely maintain the asset classes’ initial risk contributions. In performance terms, during the backtesting sample period from January 1996 to February 2013, the rebalancing strategies based on risk contributions deliver returns that are comparable to traditional value-based rebalancing strategies, but at much lower volatility levels, which translates into higher Sharpe ratios. <b>TOPICS:</b>Portfolio theory, in portfolio management, statistical methods

Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets

This article presents the most compelling empirical evidence yet of a low-risk anomaly in fixed-income markets. The authors show that portfolios invested in bonds with the lowest risk would have delivered the largest positive alpha and highest Sharpe ratios, and portfolios invested in riskier bonds would have delivered the most negative alpha and lowest Sharpe ratios. The results proved extremely robust and were confirmed for government bonds, quasi-government and foreign government bonds, securitized and collateralized bonds, corporate investment-grade bonds, corporate high-yield bonds, emerging market bonds, and aggregates of some of these universes. They considered bonds denominated in USD, EUR, GBP, and JPY separately, and the results proved invariant to the currency. The authors confirmed the robustness of the results by using different measures of risk. The results were produced using data from the Bank of America Merrill Lynch database from January 1997, which includes 85,442 individual bonds in the 192 months analyzed.

PORTFOLIO ALLOCATION BASED ON PRICE EARNINGS RATIOS

ABSTRACT We examine the risk-return tradeoff for investors using price-earnings ratios to allocate funds across bonds and stocks. Sharpe ratios are computed for portfolios consisting of 100% bonds, 100% stock, and portfolios annually changing between bonds, stocks, and mixed portfolios based on the beginning of year price-earnings ratio. Holding periods from one to 25 years are examined. Simulated portfolio returns are used to calculate Sharpe ratios for all holding periods. Our results show that price-earnings ratio based investment rules generate portfolios with higher Sharpe ratios than investing only in bonds or stocks. Keywords investor, risk-return, portfolio

Testing International Momentum Strategies between Chinese and Australian Financial Markets

This paper tests international momentum effects between Chinese Shanghai Composite Index and Australian resource stocks. If markets were efficient, there would be no profits from momentum strategies. Two momentum strategies are examined; index tracking and enhanced indexing. The enhanced indexing strategy is more profitable than the index tracking strategy, although the index tracking strategy had a higher Sharpe Ratio. Small capitalised stocks exhibit strong momentum effects. Using a newly developed partial adjustment model, support is provided for Chan et al (1996) who demonstrate that under-reaction to economic news explains momentum profits and Rouwenhorst (1998) who finds evidence of momentum effects in emerging countries.

Evidence for state and time nonseparable preferences: the case of Finland

Preferential modifications to the standard state and time separable power utility are studied for the Finnish equity and bond returns. The reported ambivalence of the high equity premium and low Sharpe ratio makes the Finnish market an important case study. The estimations of the Epstein and Zin (1991) recursive utility and the Campbell and Cochrane (1999) habit formation preferences show that Finnish risk premia are time-varying across samples. Moreover, the results demonstrate that stronger time preferences improve the explanation of asset returns for the modified preferences more so than assuming tighter time preference and higher risk aversion (RA). We conclude that the Campbell–Cochrane-based pricing kernel outperforms the competing models in generating plausible model parameters and suppressing specification errors. The study supports the US evidence relative to the conclusions drawn from the European economies in comparable studies.

Send in the Clones? Hedge Fund Replication Using Futures Contracts

Replication products strive to offer investors some of the benefits of hedge funds while avoiding their high fees, illiquidity, and opacity. The authors of this article test whether a replication algorithm can deliver the diversification and high Sharpe ratio that investors seek. Their procedure constructs monthly clone returns out-of-sample using fully collateralized futures positions held for one-month, with position sizes determined using rolling window regressions. Clone returns have high correlation with their hedge fund targets, indicating replication is possible. Clones also have high correlation with a buy-and-hold investment in stocks, however, and neither the targets nor their clones demonstrate successful time variation in factor loadings.

Low-Risk Anomalies in Global Fixed Income: Evidence from Major Broad Markets

In this paper we present the most compelling empirical evidence yet of a low-risk anomaly in fixed income markets. We show that portfolios invested in bonds with the lowest risk would have delivered the largest positive alpha and highest Sharpe ratios and portfolios invested in riskier bonds would have delivered the most negative alpha and lowest Sharpe ratios. Our results proved extremely robust and were confirmed for government bonds, quasi-government and foreign government bonds, securitized and collateralized bonds, corporate investment grade bonds, corporate high yield bonds, emerging market bonds and aggregates of some of these universes. We considered bonds denominated in USD, EUR, GBP and JPY separately and the results proved invariant to the currency. We confirmed the robustness of the results by using different measures of risk. The results were produced using data from the Bank of America Merrill Lynch database from January 1997 which includes 85,442 individual bonds in the 192 months analyzed.

Solving norm constrained portfolio optimization via coordinate-wise descent algorithms

A fast method based on coordinate-wise descent algorithms is developed to solve portfolio optimization problems in which asset weights are constrained by lq norms for 1≤q≤2. The method is first applied to solve a minimum variance portfolio (mvp) optimization problem in which asset weights are constrained by a weighted l1 norm and a squared l2 norm. Performances of the weighted norm penalized mvp are examined with two benchmark data sets. When the sample size is not large in comparison with the number of assets, the weighted norm penalized mvp tends to have a lower out-of-sample portfolio variance, lower turnover rate, fewer numbers of active constituents and shortsale positions, but higher Sharpe ratio than the one without such penalty. Several extensions of the proposed method are illustrated; in particular, an efficient algorithm for solving a portfolio optimization problem in which assets are allowed to be chosen grouply is derived.

The low return distortion of the Sharpe ratio

This article formalizes the undesirable property of the Sharpe ratio that a fund with a certain poor performance can increase its Sharpe ratio in a prospective period by generating a sufficiently negative excess return. Specifically, we set out the conditions that a fund must meet to be exposed to this kind of effect. Furthermore, we provide a formal statement of the excess return value that needs to be deceeded to obtain a higher Sharpe ratio. In an empirical application, we investigate the practical relevance of this kind of distortion. We find that an economically significant number of funds listed in the CISDM hedge fund database have at least once reported a sufficiently negative return, causing an increased Sharpe ratio fund performance.

Testing International Momentum Strategies between Chinese and Australian Financial Markets

This paper tests international momentum effects between Chinese Shanghai Composite Index and Australian resource stocks. If markets were efficient, there would be no profits from momentum strategies. Two momentum strategies are examined; index tracking and enhanced indexing. The enhanced indexing strategy is more profitable than the index tracking strategy, although the index tracking strategy had a higher Sharpe Ratio. Small capitalised stocks exhibit strong momentum effects. Using a newly developed partial adjustment model, support is provided for Chan et al (1996) who demonstrate that under-reaction to economic news explains momentum profits and Rouwenhorst (1998) who finds evidence of momentum effects in emerging countries.

Optimal Investment Portfolios with Predictable Return Signs

Expected returns of assets are notoriously difficult to estimate. Instead, investors typically have views on the mere directions of price changes, that is, whether assets are undervalued or overvalued. This paper examines how directional views affect the investor’s portfolio choice: We show that the investor prefers assets with high volatility for higher expected returns, dislikes negative return correlation between assets, and that the covariance between magnitudes of returns matters explicitly for portfolio variance. In addition, the introduced approach to portfolio selection can produce notably higher Sharpe ratios and geometric means compared to a naive alternative.

The supraview of return predictive signals

This study seeks to inform investment academics and practitioners by describing and analyzing the population of return predictive signals (RPS) publicly identified over the 40-year period 1970–2010. Our supraview brings to light new facts about RPS, including that more than 330 signals have been reported; the properties of newly discovered RPS are stable over time; and RPS with higher mean returns have larger standard deviations of returns and also higher Sharpe ratios. Using a sample of 39 readily programmed RPS, we estimate that the average cross-correlation of RPS returns is close to zero and that the average correlation between RPS returns and the market is reliably negative. Abstracting from implementation costs, this implies that portfolios of RPS either on their own or in combination with the market will tend to have quite high Sharpe ratios. For academics who seek to document that they have found a genuinely new RPS, we show that the probability that a randomly chosen RPS has a positive alpha after being orthogonalized against five (25) other randomly chosen RPS is 62 % (32 %), suggesting that the returns of a potentially new RPS need to be orthogonalized against the returns of some but not all pre-existing RPS. Finally, we posit that our findings pose a challenge to investment academics in that they imply that either US stock markets are pervasively inefficient, or there exist a much larger number of rationally priced sources of risk in equity returns than previously thought.

Easy Volatility Investing

For many decades the only way to invest in volatility has been through trading options, futures, or variance swaps. But in recent years a number of volatility-related exchange traded Funds (ETFs) and Exchange Traded Notes (ETNs) have been launched which make volatility trading accessible to the retail investor and fund managers without the need to access futures markets. Our objective is to devise a trading strategy using them. We document where volatility returns come from, clearing up some misconception in the process. Then we illustrate five different strategies that will appeal to different investors. Four of the strategies are simple to describe and implement. All of the strategies have had extraordinary returns with high Sharpe Ratios and low correlation to the S&P5'08 in some cases negative correlation. The returns seems to be too good to be true – like picking up $100 bills in front of a steamroller – so we have a detailed discussion on the risks and the nature of the steamroller. We illustrate how these strategies can be incorporated into existing portfolios to reduce portfolio risk especially in times of crisis. They have positive exposure to the markets during good times and negative exposure during bad times. Unfortunately they do not always provide absolute returns and while reducing net portfolio drawdowns they can themselves have significant drawdowns. Still, we suggest that a traditional 60% equities, 40% bonds portfolio should be adjusted to 55% equities, 35% bonds, and 10% volatility.

The Returns on Investment Grade Diamonds

Abstract: This paper examines the risk-return characteristics of investment grade gems (white diamonds, colored diamonds and other types of gems including sapphires, rubies, and emeralds). The transactions are coming from gem auctions and span the period 1999-2012. Over our time frame, the annual nominal USD returns for white and colored diamonds amount to 8.1% and 7.4%, respectively, or 5.5% and 4.8% in real terms. For a Euro investor, the returns on white and colored diamonds are about 1.3% lower than for a USD investors but the Euro returns still beat inflation by 3.5% annually. The returns for Other Gem types (rubies, emeralds and sapphires) are more volatile and somewhat lower (4.5% annual nominal returns and 2.1% in annual real terms). Applying the hedonic regression method to the data set of auction transactions of investment grade diamonds, we are able to explain more than 95% of their price variation in white diamonds. Although the diamond returns since 1999 have been below those on gold, both white and colored diamonds have significantly outperformed the US and European stock markets, US and European real estate, US government bonds, as well as European government and corporate bonds. The reward-to-risk (Sharpe ratio) of white diamonds is very close to that of US corporate government bonds. The highest Sharpe ratio (by far) over the past 14 years was the one on gold. Still, in times of crisis investments in diamonds have shown an attractive risk-return tradeoff. In spite of a small positive correlation between the diamond and the equity markets, adding diamonds to an equity portfolio still have some diversification advantages.

The Performance of NDF Carry Trades

This paper investigates the performance of carry trade strategies for currencies with non-deliverable forward (NDF) contracts. We find that carry trades for currencies with NDF contracts are associated with higher Sharpe ratios compared to carry trades for currencies with deliverable forward (DF) contracts. We also find that, during the recent financial crisis, DF carry trades incur heavy losses while NDF carry trades realize insignificant losses. DF carry trade payoffs are shaped by credit risk, global foreign exchange (FX) volatility and crash risk. In contrast, NDF carry trade payoffs are driven by global FX volatility and crash risk, liquidity risk, and currency convertibility risk measured by deviations from covered interest parity in offshore markets while global convertibility risk has a limited effect on carry trades.

Special Situation Funds

This paper provides first evidence about fund characteristics, absolute as well as risk-adjusted performance of Special Situation Funds, consisting out of hedge funds and mutual funds. Beside considerable differences in the characteristics, we document for both categories of funds a significant alpha and a higher Sharpe Ratio than the overall market during the time period from 1998 to 2012. In addition, hedge funds are less correlated to the stock market than mutual funds.

Optimal Carry and Momentum Portfolios: Diversification, Business Cycles and Speculative Capital

We provide evidence that speculative capital of hedge funds is a key determinant for the profitability of optimal carry and momentum strategies in futures markets across asset classes. We construct optimal carry and momentum portfolios from the perspective of a utility maximizing risk averse investor. The investor trades off the risk presented in the moments of his expected utility against the predictive strength of the carry and momentum signal. We parameterize the portfolio choice problem and adapt it to accommodate asset classes with varying volatility levels. We find that the returns to optimal carry and momentum strategies yield high Sharpe ratios (above 1.2) which are not a compensation for traditional risk exposure or time varying risk due to macroeconomic cycles or funding liquidity. Including optimal carry and momentum portfolios in a diversified portfolio of traditional asset factors increases the Sharpe ratios of the portfolios by on average 0.6 and reduces skewness and kurtosis. However, the returns to optimal carry and momentum portfolios are significantly related to pro cyclical hedge fund capital flows. Contemporaneously larger capital flow lead to higher optimal carry and momentum returns, implying that expected returns decrease with the total amount of assets under management by hedge funds. We argue that the predictability of expected returns in futures markets reflects the scarcity of speculative capital and is consistent with the notion of limits to arbitrage. This finding has important policy and investment implications.