Exploring Risk Models

As I continue to explore patterns in beta-client data, I clearly see one common difference.  For globally-diversified, and asset-diversified ETF- and mutual-fund-based portfolios 36-month, monthly modified-semivariance and variance based portfolios tend to converge to produce similar results.   This is in sharp contrast to stock-based portfolios, where variance (MVO) and semivariance (PMPT) portfolios display a significant trade-off between Sharpe and Sortino ratios.

My preliminary conclusion, based on poring through individual optimized-portfolios, is that variance and semivariance are closely correlated for portfolios based on sufficiently-diversified ETFs.  On the other hand, the difference between variance-optimized, semivariance-optimized, and hybrid (blend of variance- and covariance-optimized) portfolio is significantly different if individual stocks and bonds are analyzed.  [Sufficiently-diversified in this context does not mean diversified per se.  It only means relative diversification within a given ETF or set or ETFs/ETNs/Mutual Funds.)

These preliminary findings suggest that semivariance and variance based optimizations are highly correlated for certain asset classes (and expected returns) while differing for other asset classes (and expected returns).  Stock-pickers are more likely to see benefits from semivariance-based optimization than are those who select from relatively-diverse ETFs.

These preliminary findings are causing a shift in the approach taken by Sigma1.  Since, so far, Sigma1 beta partners are primarily interested in constructing portfolios based primarily or exclusively around ETFs, ETNs, and mutual funds, our company is focusing more on Sharpe ratios (because they are quicker to optimize for than Sortino ratios).

Because Sigma1 HAL0 portfolio-optimization is tuned to optimize for 3 objectives this presents an interesting question:  “Your investment company wishes to optimize portfolios based on 1) expected return, 2) minimal variance, and 3)  <RISK MEASURE 3>?”

Sigma1 is posing questions:  What is your third criterion?  What is your other risk measure?   Answer these questions, and Sigma1 HAL0 software will optimize your portfolio accordingly; showing the trade-offs between Sharpe ratios and your other chosen risk metric.

Sigma1’s 3-objective-optimization is causing a few financial-industry players to ask the question of established optimization engines, “Can you do that?”  Sigma1 Software can.  Can your current portfolio-optimization software do the same?