Portfolio Structure Optimization through GeWorko Method

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IFC Markets is glad to inform that GeWorko method has recently become available in the trading platform NetTradeX. It is to assist traders in constructing and analyzing multiple variations of investment portfolios, consisting of a large set of various financial assets.

Searching for an optimal structure of assets in a portfolio is obviously not an easy task for every trader nowadays, because much depends both on the parameters of assets included in the portfolio, and on the individual preferences and constraints of the investor. However, modern financial theory and new methods of analysis and trading, to which just born GeWorko method refers, significantly simplify this process.

GeWorko method allows the use of popular investment strategies of active portfolio management. One of them implies finding a set of assets that, while maintaining a relatively high degree of portfolio diversification, could systematically outperform a "passive" portfolio, understood as the market itself.

From the composition of the well-known index Dow Jones Industrial Average (market) which has only recently managed to complete its post-crisis recovery, it is possible to highlight some stocks that have shown one of the best price performances in recent years. These stocks are included in the "active" portfolio:

1.    Walt Disney Company
2.    Home Depot Inc.
3.    Honeywell International Inc.
4.    International Business Machines Corporation
5.    Coca-Cola Company
6.    McDonald’s Corporation

The above mentioned six stocks were selected merely as an example and have no intention of providing investment advice.

Now, GeWorko method allows everyone the use of popular investment strategies of active portfolio management. Despite of consisting of the same assets, each portfolio will have the necessary risk and return parameters for the investor (all subsequent calculations are based on monthly close prices of stocks, adjusted for the corresponding index values, for the sample January 2005 - April 2013).

Maximum Sharpe Ratio

For example, the maximum return per unit of risk, also known as Sharpe ratio, can be considered a criterion for an optimal portfolio. In this case the optimization procedure for the selected stocks leads to the following set of weight coefficients in the respective order: (19.33%; 10.96%; 19.04%; 7.71%; 10.28%; 32.67%). This portfolio structure provided the highest historical risk-return ratio (Sharpe ratio is equal to 0.30) among all possible portfolios, consisting of the selected six stocks. Through GeWorko method a chart of the value of the portfolio in relation to the index Dow Jones Industrial Average can be easily built (see Chart 1).

The maximum return for a given level of risk

Achieving the highest possible return for a given level of risk can serve as another criterion for an optimal portfolio. For example, if the maximum acceptable standard deviation of the portfolio return is 2.5%, maximization of the realized return would lead to the following solution for the weight coefficients: (21.74%; 0.84%; 14.17%; 1.61%; 0% and 61.63%). As a result, the new portfolio, compared to the previous one, showed a higher historical return - it increased from 0.52% to 0.65%. Chart 2, built with GeWorko method, clearly confirms that, along with return, the volatility of the portfolio has increased as well, as evidenced by stronger fluctuations of its relative value.

Minimum level of risk

If the optimization problem is minimizing the risk, the solution leads to a new portfolio structure in the corresponding order of stocks: (17.11%; 13.89%; 20.77%; 8.75%; 21.35% and 18.13%). This portfolio is characterized by the least possible realized standard deviation of return (1.60%) among all portfolios, consisting of the same set of stocks. GeWorko method again will help to build a chart of the portfolio in relation to the index (see Chart 3). It is just amazing how smooth the portfolio’s value growing curve looks now, compared to the previous two options - a direct consequence of risk reduction.

Charts, built with GeWorko method, clearly confirm the possibility of using the principles of modern portfolio theory. Based on the quantitative estimates of risk, return and correlations of various assets, GeWorko method allows building portfolios that would have been systematically outperforming the market for several years, meeting the most diverse investment preferences.
In this case, the analogs of the (1) tangency portfolio maximizing the Sharpe ratio, (2) portfolio lying on the efficient frontier, with a given level of risk, and (3) minimum-variance portfolio have been presented. All of them are well-known thanks to the mean-variance framework of Harry Markowitz, who in fact developed the basic principles of the modern portfolio theory.

All the advantages of GeWorko method are already available in the trading-analytical platform NetTradeX.

To get more information about calculations and charts, please, follow the link: http://www.ifcmarkets.com/en/portfolio-trading/portfolio-optimization-through-geworko-method-part-1

About IFC Markets:
IFC Markets is providing Forex (Foreign Exchange) and CFD (Contracts for Difference) trading and associated services for both individual and corporate clients. http://www.ifcmarkets.com

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