Approaching the Frontier

Disclosure: The purpose of this post is to show how I, personally, use the HALO Portfolio Optimizer software to manage my personal portfolio. It is not investment advice! I use my personal opinions about which assets to select and expected one-year returns into the optimizer configuration.  The optimizer then provides an efficient frontier (EF) based on historic total-return data and my personal expected-return estimates.

I use other software (User Tuner) to approach the EF, while limiting the number and size of trades (minimizing churn and trading costs).  Getting exactly to the EF would require trading (buying or selling) every asset in my portfolio — which would cost approximately $159 in trading costs for 18 trades. Factoring in bid/ask spreads the cost would be even higher.  However, by being frugal about trades, I was able to limit the number of trades to 6 while getting much closer to the EF.

Past performance is no guarantee of future performance, nor is past volatility necessarily indicative of future volatility.  Nonetheless, I am making the personal decision to use past volatility information to possibly increase the empirical diversification of my retirement portfolio with the goal of increasing risk-adjusted return.  Time will tell whether this approach was successful or not.

In my last post I blogged about reallocating my entire retirement portfolio closer to the MVO efficient frontier computed by the HALO Portfolio Optimizer.  The zoomed in plot tells the story to date:

5_7_2014_realloc

The “objective space” plot is zoomed in and only shows a small portion of the efficient frontier. As you can see the black X is closer to the efficient frontier than the blue diamond, but naturally the dimensions are not the same. Using a risk-free rate of 0.5% the predicted Sharpe ratio has improved from 0.68 to 0.75 – a marked increase of about 10.3%.  [If you crunch the numbers yourself, don’t forget to annualize σ.]

While a 10.3% Sharpe ratio expected improvement is very significant, there is obviously room for compelling additional improvement. An expected Sharpe ratio of just north of 0.8 is attainable.

The primary reason the portfolio has not  yet moved even closer to the efficient frontier is due to 18.6% of the retirement portfolio being tied up in red tape as a result of my recent voluntary severance or “buy-out” from Intel Corporation. [ Kudos to Intel for offering voluntary severance to all of my local coworkers and me.  It is a much more compassionate method of workforce reduction than layoffs!  I consider the package offered to me reasonably generous, and I gladly took the opportunity to depart and begin working full time building my start up.]

Time to Get Technical

I won’t finish without mentioning a few important technical details. The points in the objective space (of monthly σ on the horizontal and expected annual return on the vertical) can be viewed as dependent variables of the (largely) independent variables of asset weights. Such points include the blue diamond, the black X, and all the red triangles on the efficient frontier. I often call the (largely) independent domain of asset allocation weights the “search space”, and the weightings in the search space that result in points on the efficient frontier the “solution space.”

One way to measure the progress from the blue diamond to the X is via improvement in the Sharpe ratio, which implicitly factors in the CAL, or the CML for the tangent CAL.  As “X” approaches the red line visually it also approaches the efficient frontier quantitatively and empirically.  However, X can make significant progress towards the efficient frontier, say point EF#9 specifically, with little or no “progress” in the portfolio weights from the blue diamond to the black X.

“Progress” in the objective space is reasonably straight forward — just use Sharpe ratios, for instance. However measuring “progress” in the asset allocation (weight) space is perhaps less clear. Generally, I prefer the use of the L1-norms of differences of the asset-weight vectors Wo (corresponding to original portfolio weight; e.i. the blue diamond), Wx, and Wef_n. The distance of from the blue diamond  in search space to the red triangle #9 is denoted as |Wef_9 – Wo|1 while the distance from X in the search space is |Wef_9Wx|1.  Interestingly, the respective values are 0.572 and 0.664.  Wis, by this measure, actually further from Wef_9 in search space, but closer in objective space!

I sometimes refer to these as the “Hamming distances” (even though “Hamming distance” is typically applied to differences in binary codes or character inequality counts of two strings of characters.) It is simply easier to say the “Hamming distance from Wx to Wef_9” than the “ell-one norm of the difference of Wx and Wef_9.”

I have been working on an utility temporarily called “user tuner” that makes navigating in both the search space and the objective space quicker, easier and more productive. More details to follow in a future post.

Why Not Semi-Variance Optimization?

Frequent readers will know that I believe that mean semi-variance optimization (MSVO or SVO) is superior to vanilla MVO. So why am I starting with MVO? Three reasons:

  • To many, MVO is less scary because it is somewhat familiar. So I’m starting with the familiar “basics.”
  • I wanted to talk about Sharpe ratios first, because again they are more familiar than, say, Sortino ratios.
  • I wanted to use “User Tuner”, and I originally coded it for MVO (though that is easily remedied).

However, asymptotically refining allocation of my entire portfolio to get extremely close to the MVO efficient frontier is only phase 1.  It is highly likely I will compute the SVO efficient frontier next and use a slightly modified “User Tuner” to approach the mean semi-variance efficient frontier… Likely in the next month or two, once my 18.6% of assets are freed up.