Active Portfolios: Diversification Across Trading Strategies
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Several characteristics of a firm and its past return have been shown to be useful in predicting future returns, leading to long-short trading strategies with positive expected return using no invested capital. I develop the idea of active portfolios, which treat these long-short strategies as investable assets. I show that, since the returns from these long-short strategies are largely uncorrelated, active portfolios which make simultaneous bets on several long-short strategies have Sharpe ratios several times that of the market and extremely attractive return characteristics. I argue that this is because the diversification achievable in active portfolios exceeds that attainable through traditional sources of diversification. Keywords: long-short trading strategies, value, momentum, diversification. 1 Introduction Researchers have found a large number of long-short trading strategies that earn significant return with no invested capital. These strategies can be roughly categorized as momentum [5, 11], value [3, 8, 9, 12], firm size [6, 8] and reversal on a long [2, 7] and short [10, 13] time scale. These strategies sort stocks by one of the above criteria every month, then go long a portfolio of stocks that strongly exhibit that criteria and short a portfolio that weakly exhibit it. The return is the spread between the two portfolios. Different studies have used different samples, methodologies, and time periods to find different return spreads from these trading strategies, but a large amount of research supports the view that the above strategies have positive expected return. I look at the performance of \“active” portfolios, which treat long-short trading strategies as investable assets and which follow several strategies at once. They are \“active” because the trading strategies turn over some of their capital every
long-short trading strategies, value, momentum, diversification.