GBA Workbench – Targeted Volatility Algorithm

Targeted Volatility

This algorithm performs a standard mean-variance optimization over a group of instruments in a portfolio. The algorithm constructs an efficient frontier of instrument weightings and allows the user to choose a weighting at the beginning of each re-allocation period based on risk preference from 1 (the lowest risk potentially available for the portfolio) to 20, the highest potential risk.

The algorithm is based on Modern Portfolio Theory.

As per Investopedia:

“Modern Portfolio Theory (MPT), a hypothesis put forth by Harry Markowitz in his paper “Portfolio Selection,” (published in 1952 by the Journal of Finance) is an investment theory based on the idea that risk-averse investors can construct portfolios to optimize or maximize expected return based on a given level of market risk, emphasizing that risk is an inherent part of higher reward. It is one of the most important and influential economic theories dealing with finance and investment.

Also called “portfolio theory” or “portfolio management theory,” MPT suggests that it is possible to construct an “efficient frontier” of optimal portfolios, offering the maximum possible expected return for a given level of risk. It suggests that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification, particularly a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.”

Investopedia

The user can set the following parameters specific to this algo:

  • “Risk Tolerance” (from 1 to 19 – from lower back tested volatility and return to higher)
  • “Lower Bounds” (the minum weighting for each instrument at each re-allocation date; an often used default is 0.00)
  • “Upper Bounds” (the maximum weighting for each instrument at each re-allocation date; an often used default is 1.00)
  • “Lookback” (the lookback period for which portfolio returns and volatility will be calculated, in months)
  • “Re-allocation Period” (the period at the beginning of which the portfolio will be re-weighted)

In the back test below:

Portfolio:

  • fgovx,Fidelity Government Income Fund
    sp500tr,S&P 500 Total Return Index

Parameters:

  • Risk Preference 20
  • Bounds (0,1)
  • Lookback 3 months
  • Re-allocation monthly

targVol1

Stat                 Targeted Volatility    S&P
-------------------  ---------------------  ----------
Start                1988-01-04             1988-01-04
End                  2016-12-20             2016-12-20
Risk-free rate       0.00%                  0.00%

Total Return         1587.61%               1593.83%
Daily Sharpe         0.90                   0.64
CAGR                 10.25%                 10.26%
Max Drawdown         -18.29%                -55.25%

MTD                  3.42%                  3.38%
3m                   -0.30%                 6.69%
6m                   2.95%                  10.17%
YTD                  -0.14%                 13.50%
1Y                   1.83%                  15.74%
3Y (ann.)            -1.22%                 9.99%
5Y (ann.)            6.01%                  15.28%
10Y (ann.)           7.89%                  7.06%
Since Incep. (ann.)  10.25%                 10.26%

Daily Sharpe         0.90                   0.64
Daily Mean (ann.)    10.42%                 11.33%
Daily Vol (ann.)     11.53%                 17.69%
Daily Skew           -0.33                  -0.12
Daily Kurt           5.57                   8.86
Best Day             5.11%                  11.58%
Worst Day            -6.86%                 -9.03%

Monthly Sharpe       1.06                   0.76
Monthly Mean (ann.)  10.28%                 10.83%
Monthly Vol (ann.)   9.70%                  14.27%
Monthly Skew         -0.21                  -0.57
Monthly Kurt         1.02                   1.26
Best Month           9.01%                  11.43%
Worst Month          -9.03%                 -16.79%

Yearly Sharpe        0.89                   0.66
Yearly Mean          11.29%                 11.71%
Yearly Vol           12.66%                 17.75%
Yearly Skew          0.39                   -0.83
Yearly Kurt          -1.03                  0.77
Best Year            34.92%                 37.57%
Worst Year           -8.90%                 -37.00%

Avg. Drawdown        -1.72%                 -2.18%
Avg. Drawdown Days   26.56                  30.29
Avg. Up Month        2.31%                  3.26%
Avg. Down Month      -2.16%                 -3.39%
Win Year %           78.57%                 82.14%
Win 12m %            81.60%                 81.60%
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