Assume you have a bunch of different systems that trade stocks, equity index ETFs, bond ETFs, and some other alternative assets, eg commodity ETFs. All the systems take both long and short positions. What are the questions your portfolio optimization approach must answer? This is a post focused on high-level conceptual issues rather than implementation details.

 

Do I want market factor exposure?

By “market factor” I refer to the first component that results from PCAing a bunch of equities (which is similar but not identical to the first factor in all the different academic factor models). In other words it’s the underlying process that drives global equity returns as a whole.

Case A: Your system says “go long SPY”. This is simple: you do want exposure to the market factor. This is basically a beta timing strategy: you are forecasting a positive return on the market factor, and using the long SPY position to capture it. Risk management basically involves decreasing your SPY exposure until you hit your desired risk levels.

Case B: Your system says “go long SPY and short QQQ”. Suddenly this is not a beta timing strategy at all, but something very different. Clearly what we care about in this scenario is relative performance of the unique return components of SPY and QQQ. Therefore, we can think about this as a kind of statistical arbitrage trade. The typical approach here is to go beta neutral or dollar neutral, but naive risk parity is also reasonable.

Case C: Your system says:

• Go long SPY
• Go long EFA
• Go long AAPL
• Go long AMZN
• Go short NFLX

I’m going long the entire world, and short NFLX. This looks more like a beta timing trade (Case A) rather than a statarb-style trade (Case B), because the number and breadth of the trades concentrated on the long side indicate a positive return on the market factor. I probably don’t want to be beta neutral in this case. Not every instance of long/short equity trades can be boiled down to “go market neutral”. So how do we determine if we want to be exposed to the market factor or not?

One intriguing solution would be to create a forecasting model on top of the strategies: it would take as input your signals (and perhaps other features as well), and predict the return of the market factor in the next period. If the market factor is predicted to rise or fall significantly, then do a beta timing trade. If not, do a beta-neutral trade. If such forecasting can add value, the only downside is complexity.

 

Is the market factor enough?

Let’s say you trade 5 instruments: 3 US ETFs (SPY, QQQ, IWM), a Hong Kong ETF (EWH), and a China ETF (FXI). Let’s take a look at some numbers. Here are the correlations and MDS plot so you can get a feel for how these instruments relate to each other:

 

 

PCAing their returns shows exactly what you’d expect: the first component is what you’d call the market factor and all the ETFs have a similar, positive loading. The second component is a China-specific factor.

And here’s the biplot:

Case D: Your systems say:

• Go long SPY
• Go long EWH
• Go short FXI

In this situation there is no practical way to be neutral on both the global market factor and the China-specific factor. To quickly illustrate why, consider these two scenarios of weights and the resulting factor loadings:

Weights				Factor Loadings
SPY	EWH	FXI		PC1	PC2
0.45	0.5	-1		0.01	-0.39
0.5	0.65	-0.4		0.35	-0.01

Should we try to minimize both? Should we treat EWH/FXI as an independent statarb trade and neutralize the China factor, and then use our SPY position to do beta timing on the global market factor? How do we know which option to pick? How do we automate this decision?

A similar problem comes up if we segment the market by sectors. It’s possible that your strategy has a selection effect that causes you to be overweight certain sectors (low volatility equity strategies famously have this issue), in which case it might be prudent to start with a per-sector risk budget and then optimize your portfolio within each sector separately.

If you’re running a pure statarb portfolio, this is an easy decision, and given the large number of securities in your portfolio there is a possibility of minimizing exposure not only to the market factor but many others as well. For more on how to practically achieve this, check out Valle, Meade & Beasely, Factor neutral portfolios.

 

Do I want exposure to other, non-equity factors?

Sometimes.

Let’s see what happens when we add TLT (20+ year treasuries) and GDX (gold miners) to our asset universe. Correlations and MDS:

PCA:

Some things to notice: as you’d expect, we need more factors to capture most of the variance. On top of that, the interpretation of what each factor “means” is more difficult: the first factor is still the market factor, but after that…my guess is PC2 is interest-rate related, and PC3 looks China-specific? In any case, I think the correct approach here is to be agnostic about what these factors “mean” and just approach it as a purely statistical problem.

At this point I also want to note that these factors and their respective instrument loadings are not stable over time. Your choice of lookback period will influence your forecasts.

Again we run into similar problems. If your systems say “go long GDX”, that looks like a beta timing play on PC2/3?/4?. But let’s say you are running two unrelated systems, and they give you the following signals:

Case E:

• Long TLT
• Short GDX

Should we treat these as two independent trades, or should we treat it as a single statarb-style trade? Does it matter that these two instruments are in completely different asset classes when their PC1 and PC2 loadings are so similar? Is it a relative value trade, or are we doing two separate (but in the same direction) beta-timing trades on PC4? Hard to tell without an explicit model to forecast factor returns. If you don’t know what is driving the returns of your trades, you cannot optimize your portfolio.

 

Do I treat all instruments equally?

Depends. If you go the factor-agnostic route and treat everything as a statistical abstraction, then perhaps it’s best to also be completely agnostic about the instruments themselves. On the other hand I can see some good arguments for hand-tailored rules that would apply to specific asset classes, or sub-classes. Certainly when it comes to risk management you shouldn’t treat individual stocks the same way you treat indices — perhaps this should be extended to portfolio optimization.

It also depends on what other instruments you include in your universe. If you’re only trading a single instrument in an asset class, then perhaps you can treat every trade as a beta timing trade.

 

How do I balance the long and short sides?

In a simple scenario like Case B (long SPY/short QQQ) this is straight-forward. You pick some metric: beta, $, volatility, etc. and just balance the two sides.

But let’s go back to the more complex Case C. The answer of how to balance the long and short sides depends on our earlier answer: should we treat this scenario as beta timing or statarb? The problem with the latter is that any sensible risk management approach will severely limit your NFLX exposure. And since you want to be beta (or $, or σ) neutral, this means that by extension the long side of the trade will also be severely limited even though it carries far less idiosyncratic risk.

Perhaps we can use the risk limits to determine if we want to be beta-neutral or not. If you can’t go neutral because of limits, then it’s a beta timing trade. Can you put your faith into such a hacky heuristic?

What do we do in situations where we’re having to balance a long/short portfolio with all sorts of different asset classes? Do we segregate the portfolio (by class, by factor loading?) in order to balance each part separately? As we saw in Case E, it’s not always clear which instruments go into which group.

 

 

How do I allocate between strategies?

So far we’ve been looking at instruments only, but perhaps this is the wrong approach. What if we used the return series of strategies instead? After all the expected returns distribution conditional on a signal being fired from a particular strategy is not the same as the unconditional expected returns distribution of the instrument.

What do we do if Strategy A wants to put on 5 trades, and Strategy B wants to put on 1 trade? Do we care about distributing the risk budget across instruments, or across strategies, or maybe a mix of both? How do we balance that with risk limits? How do we balance that with factor loadings?

 

So, to sum things up. The ideal portfolio optimization algorithm perfectly balances trading costs, instruments, asset classes, factor exposure (but only when needed), strategies, and does it all under constraints imposed by risk management. In the end, I don’t think there are any good answers here. Only ugly collections of heuristics.