Enhancement of Sharpe Ratios

The Sharpe Ratio is one of the most-used indicators for people to compare mutual funds to find the ones with the best risk-adjusted returns.

 

We offer tools to help fund managers enhance the Sharpe Ratios of their portfolios. For funds invested in multiple countries, we help you to determine optimal weighting of countries while for single-country portfolios, we help you to determine optimal weighting of sectors. These weightings could comply with your constraints on max/min weighting for each market or sector.

These are the steps we employ to enhance the Sharpe Ratio for a particular country via sector allocation. We will use the Australian market as an example.

 

1. Determining the expected return of each sector by looking at its fair valuation based on historical norms as well as its fundamentals (earnings, sales, etc.) for the next two years.

 

As explained under Market Absolute Performance, knowing an asset’s average historical valuation and its future fundamentals (e.g. earnings, sales, cash flow, etc.) helps us to come up with expected returns for each sector.

The following is an example of the Composite Valuation chart for the Australian Consumer Discretionary Sector. If the sector trades at fair valuation (i.e. on the red line) in two years’ time, it is expected to generate a return of 6.3%.

This is done for all sectors in order to come up with expected returns as per the table below.

 

2. Determining the volatility of the sector’s return over and above the risk-free rate.

Using monthly data over 20 years, we calculate the volatility of each sector’s return over the risk-free rate.

 

3. Determining the co-variance of each sector with the other sectors.

While sectors by themselves may be volatile, many sectors are not well correlated to each other as they are driven by unique factors. In fact, correlation between sectors is less than 50% most of the time (as indicated by the green cells) providing tremendous opportunities to mix and match sectors in a way that will reduce total portfolio volatility.

 

After having done the three steps above, our model will calculate optimal sector weightings so that the Sharpe ratio of your portfolio is maximized. This will take into consideration constraints that we set for maximum and minimum weightings for each country or sector. In our example, we set the constraints that sector weights must not deviate by more than 10% under or over its neutral market weighting (e.g. neutral weighting 20% means allowable weighting is 10% to 30%). We are able to work with any weighting guidelines that you may have.

As a result of these new weightings, expected return of the Australian portfolio is expected to improve from -6.3% to +3.5% and the Sharpe Ratio from -0.53 to +0.25.

 

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