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How to Build Your Portfolio Like a Professional InstitutionInvesting at the institutional level involves a sophisticated blend of strategies, risk management, and performance measurement to achieve optimal returns. One of the cornerstones of creating an institutional-grade portfolio is the use of optimization methods, with particular focus on ratios such as the Sharpe Ratio, Sortino Ratio, and Omega Ratio. In this guide, we'll delve into what these ratios are, how they differ, and when to use each to construct a robust institutional-grade portfolio. Understanding the Ratios Sharpe Ratio Definition : The Sharpe Ratio, developed by Nobel laureate William F. Sharpe, measures the performance of an investment compared to a risk-free asset, after adjusting for its risk. It is calculated by subtracting the risk-free rate from the return of the portfolio and dividing by the standard deviation of the portfolio's excess returns. Usefulness : This ratio helps investors understand how much excess return they are receiving for the extra volatility that they endure for holding a riskier asset. A higher Sharpe Ratio indicates a more attractive risk-adjusted return. Sortino Ratio Definition : Similar to the Sharpe Ratio, the Sortino Ratio also measures the risk-adjusted return of an investment portfolio. However, it differs by only considering downside volatility (negative returns) rather than the total volatility of returns. Usefulness : This focus on downside risk makes the Sortino Ratio particularly useful for investors who are more concerned about potential losses than the overall volatility. A higher Sortino Ratio indicates that the portfolio is efficiently earning more on its downside risk. Omega Ratio Definition : The Omega Ratio is a more comprehensive measure that divides the returns above a certain threshold (typically the risk-free rate) by the returns below that threshold. It considers all the moments of the distribution of returns, not just the first two moments (mean and variance) like the Sharpe and Sortino ratios. Usefulness : This ratio is especially valuable for portfolios that do not follow a normal distribution of returns, providing a more holistic view of performance across different risk levels. A higher Omega Ratio indicates better performance per unit of risk. How They Differ The primary difference among these ratios lies in how they measure risk and returns: Sharpe Ratio considers the total volatility (standard deviation) of portfolio returns, treating all volatility as equal. Sortino Ratio improves on this by focusing only on downside risk, which is more relevant for investors concerned about losses. Omega Ratio goes further by considering the entire distribution of returns, offering insights into the performance across all levels of risk. Situational Use Sharpe Ratio : Ideal for general comparisons of portfolio performance where the investor is concerned with both upside and downside volatility. It's particularly useful when comparing portfolios or investments with similar risk profiles. This ratio is commonly used by most large financial institutions due to the large sums of money they manage and ensuring portfolio stability is prioritized over larger profits. Sortino Ratio : Best used when the investor's primary concern is with the downside risk rather than total volatility. This ratio is suitable for portfolios where strategies are aimed at minimizing losses rather than capturing every potential upside. This ratio is used by investors who are able to stomach more volatility in their portfolio in return for a higher probability of gains while effectively reducing equity downside. Omega Ratio : Most beneficial for analyzing portfolios with non-normal distributions of returns, such as those including options, leveraged investments, or hedge funds. It provides a nuanced view of performance across different levels of risk, making it suitable for sophisticated investment strategies that aim to manage risk in a more granular manner. Due to the nature of this ratio, only investors who have a larger risk appetite and require aggressive growth should use this ratio as the omega ratio will not necessarily be affected by high portfolio drawdowns as long as the runups are significantly higher. This means a portfolio could experience a 60% drawdown, followed by a 1000% runup, and the Omega Ratio calculation would return a high value as the probability of gains still outweigh the probability of losses. Conclusion Constructing an institutional-grade portfolio requires a nuanced understanding of both the opportunities and risks present in the investment landscape. By leveraging the Sharpe, Sortino, and Omega ratios, investors can better assess the risk-adjusted performance of their portfolios, tailoring their investment strategies to meet specific risk and return objectives. Whether you're managing a conservative fund focused on minimizing losses or a dynamic portfolio seeking to capitalize on market inefficiencies, these ratios provide critical insights that can help optimize your investment approach for superior risk-adjusted returns.
NASDAQ:TSLAEducation
by AlgoAlpha
2
The 3 Musketeers of Risk AnalysisIntroduction: In the world of investing, managing risk is as crucial as seeking returns. Three vital tools for assessing risk-adjusted returns are the Sharpe Ratio, Sortino Ratio, and Omega Ratio. In this post, we'll explore these ratios, their calculation, their unique features, and when to use them. 1. Sharpe Ratio: Balancing Risk and Return Measures risk-adjusted returns using total volatility (both up and down). Formula: (Return - Risk-Free Rate) / Portfolio Standard Deviation. Strength: Widely accepted and provides a simple assessment of risk-adjusted return. Weakness: Assumes normal distribution and ignores skewness. 2. Sortino Ratio: Focusing on Downside Risk Emphasizes downside risk. Formula: (Return - Risk-Free Rate) / Downside Deviation (only negative returns). Strength: Ideal for risk-averse investors and non-normally distributed returns. Weakness: Ignores upside volatility. 3. Omega Ratio: Probability of Positive Returns Evaluates risk-adjusted returns based on the probability of achieving positive returns. Formula: Probability of Positive Returns / Probability of Negative Returns. Strength: Provides insights into return probabilities and considers tail events. Weakness: Less recognized and may require more data. Conclusion: Understanding these ratios helps investors make informed decisions. The Sharpe Ratio simplifies risk-return assessment, the Sortino Ratio prioritizes downside protection, and the Omega Ratio analyzes return probabilities. Combining these ratios offers a comprehensive view of investment performance in an unpredictable financial world.
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NASDAQ:NVDAEducation
by AutomatedTradingAlgorithms
3
How Much Gold Does Your Portfolio Need?Economists make forecasts to make weathermen look good. Trying to forecast trends in complex systems is never easy. As with weather, financial markets are influenced by a myriad of factors which can make prediction akin to gambling. Time in the market beats timing the market so a far safer bet is building a diversified and informed portfolio. As mentioned in our previous paper , gold is a crucial addition to any well-diversified portfolio. Gold offers investors the benefits of resilience during crises, diversification, and low volatility while also being a good hedge against inflation. With crisis ever-present, from pandemics and geo-political conflict to financial instability and recession, uncertainty is on everyone’s lips, including central banks which bought a record 1,135 tonnes of gold last year. Central Banks have shown no signs of slowdown going into 2023, buying 74t in Jan and 52t in Feb, the strongest start to central bank buying since 2010. It is clear why, with rising global inflation due to 2 years of unprecedented QE. A decade of cheap money has its costs which are coming back to bite both consumers and central banks. This is now being played with collapsing banks and crumbling businesses. Though governments may term these exceptions, they’re the inevitable consequence of hiking rates too fast. And even though inflation has now started to cool, it is proving stubborn and the risk of recession looms. In crisis, institutions and individuals rush to gold. It’s no wonder then that gold prices spiked in March nearing an All-Time-High above USD 2,000/oz. Gold continues to trade above the key 2000 level even in April. Even now crises show no sign of slowing. Recession talks have become commonplace and phantoms of 2008 haunt with bank collapses. The world is increasingly moving towards reshoring and friendshoring, and de-dollarization is talked about more and more. It is almost inevitable that gold will break its all-time-high soon. But, buying gold is the easy part, in fact, our previous paper covered 6 Ways to Invest in Gold. Managing gold as part of a larger portfolio is more nuanced. Allocating the right amount, finding the right entry, and knowing when to cash out are all critical. This paper aims to address two questions – 1. What are the key drivers of gold prices in this decade 2. How should investors use gold in balancing portfolios to navigate turbulent times? What Propels Gold After Its All Time High? SVB and Credit Suisse pushed it to its brink. In fact, spot prices in India, Australia, and the UK sailed even above their All-Time-High. But what propels gold now? Financial Instability Was Credit Suisse the End? “The current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come.” - Jamie Dimon Unfortunately, Credit Suisse was likely just a symptom of the larger problem. 2-years of near-free money has inevitably led others to make risky bets which catch up to them during periods of QT. Additionally, Credit Suisse and SVB’s collapse were both set off by an unprecedentedly aggressive rate hiking cycle. Fed is stuck between a rock and a hard place as they try to control runaway inflation with aggressive rate hikes. Higher rates for longer increase the risks of financial instability. Stubborn Inflation and Recession Risks Stubborn inflation? Wasn’t inflation on its way down after almost a year? Yes and No. Although yearly inflation has definitely cooled in most countries from their peak last year, inflation continues to tick up month-by-month above the targets that central banks have set for themselves. It is not expected to reach below their targets even before 2025 in many countries. This is because although energy and commodity prices have cooled with demand waning, core inflation continues to remain stubbornly high. Additionally, food and energy prices are still volatile. On the back of this, recession risks remain high. Recently released FOMC meeting minutes showed that officials expect a recession in the second half of the year. A recession in many countries now seems inevitable. Gold shines during recession and high-inflation environments. High Interest Rates Wasn’t the Fed done hiking? Currently, CME’s FedWatch tool shows a ~72% chance of another 25bps hike next month despite the surprisingly low US CPI print. Does another 25bps matter? What’s more important is that 25bps is the peak rate and most central banks are calling this summit a pause and not a pivot. As such, rates will likely remain high for the remainder of 2023. Gold tends to perform well during high interest rate and risk-off environments. Escalating Tensions, Friendshoring, and De-Dollarization Last but definitely not least are central banks and their gold-buying binge. Though some of this can be explained by the ultra-high inflation. It is undeniably also driven by rising political tensions. The conflict in Ukraine continues to rage and the US extend its trade war against China with the CHIPS act. This is driving many of the largest economies to reshore and friendshore key supply chains. This also means relying less on the USD which can be weaponized by the US. De-dollarization has been underway for the last 23 years as the share of USD holdings in foreign exchange reserves has declined from 71.5% to 58.3% over the past 23 years. Current conditions make it more likely that the trend will accelerate. Gold inevitably benefits from all of this as it is one of the only assets that no other central bank can print or freeze. All of these factors will likely drive gold in the coming decade. But instead of setting a price target, investors can be prudent and methodical by properly allocating it as part of a larger portfolio. Using Gold in a Portfolio From 2000 until now, the following portfolios would deliver: Since 2000, gold has been the best performing asset out of the 3 main components of a basic portfolio – Large Cap stocks (SPY), Treasury Bonds (10Y), and Gold. Gold price has risen 609% compared to SPY at +193%. Investing in 10-year maturity treasury bonds would have netted investors 110% during these 23 years. As such, larger portfolio allocation towards gold would have yielded investors far more during this period. However, this comes at the downside of higher volatility. Gold has had an average 12-month rolling volatility of 15.8% over the last 23 years, slightly higher than SPY’s 14%. Still, not all volatility is bad, especially if the returns outweigh the risk. Volatility to the upside can be beneficial to investors. In order to measure the returns from the portfolio after accounting for higher volatility-associated risk, investors can measure the risk-adjusted returns using the Sharpe Ratio and Sortino Ratio. Sharpe Ratio measures the amount of excess return generated by taking on additional volatility-related risk. The higher the Sharpe Ratio, the better the portfolio is performing relative to its risk. The figure below contains the Sharpe Ratio for each of the portfolios across the last 23 years. Since each year had a different risk-free rate due to changing monetary policy, the Sharpe ratios vary for every year and there are periods during which gold-heavy portfolios have highest Sharpe ratios and others where it has the lowest. This highlights gold's sensitivity to changes in monetary policy. Sortino Ratio also measures risk-adjusted returns like the Sharpe Ratio however it only considers the risk of downside volatility. In other words, it measures return for every unit of downside risk. The figure below contains the Sortino Ratio for each of the portfolios. A key difference between the Sharpe and Sortino Ratios can be seen in the readings for 2009. Sharpe Ratio for a gold-heavy portfolio is the lowest in 2009 due to high volatility in gold prices. However, since this was volatility to the upside, the Sortino Ratio for a gold-heavy portfolio in 2009 is the highest. In 2023, a Gold heavy portfolio has performed the best and has the highest Sharpe and Sortino Ratio due to gold's relative overperformance amid the banking crisis. DISCLAIMER This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services. Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
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COMEX:GC1!Education
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