The Pitfalls of Portfolio Optimization

Beware of the man selling high Sharpe portfolios

June 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Sharpe ratio-optimized multi-asset portfolios deteriorate significantly out-of-sample
  • Targeting volatility only does marginally better
  • Simple equal-weighting across asset classes holds up surprisingly well

INTRODUCTION

In his book “Expert Political Judgment”, Philip Tetlock presents the results of a landmark study spanning two decades, analyzing 82,361 forecasts made by 284 experts in political and economic fields. The findings were sobering: experts performed only slightly better than random chance.

Yet despite being published in 2005, the book does not appear to have dented society’s faith in experts. The asset management industry is a case in point. The S&P SPIVA Scorecards consistently show that more than 90% of active fund managers – experts in stock picking – fail to outperform their benchmarks, regardless of time frame or market. Still, trillions of dollars remain invested with active managers, despite their terrible odds.

Portfolio optimization represents another area of investing where expert-driven approaches are widely overvalued. In this research article, we explore why – and how – that trust may be misplaced.

SHARPE RATIO OPTIMIZATION

While some investors aim to optimize a portfolio by maximizing total return, this approach is fundamentally flawed, as it ignores the level of risk required to achieve those returns. In fact, given the availability of leveraged S&P 500 ETFs, it’s relatively easy to “beat” the market, albeit at the cost of significantly higher risk.

A more sensible objective is to maximize the Sharpe ratio, which accounts for both return and risk. To explore this, we construct a universe of diverse ETFs offering exposure to various asset classes, sectors, and strategies, all of which have been available since 2004. Using this universe, we create in-sample (IS) portfolios based on maximizing the Sharpe ratios during a five-year lookback period, which are then held for the subsequent five years.

Starting in 2004, we observe that the composition of the Sharpe-optimal portfolios changes meaningfully from one period to the next. For instance, the portfolio optimized