2
$\begingroup$

I have come across a portfolio selection strategy that buys in equal amounts the top decile of expected earners, and simultaneously short sells the lowest decile in a similar fashion. What is this strategy called? I am looking for words more specific than "market/dollar neutral."

$\endgroup$
1
$\begingroup$

Short answer: This 'portfolio sort' is rather a common approach in empirical finance research, than a portfolio strategy.


Your mentioned strategy is called 'portfolio analysis' or in more detail a 'univariat portfolio sort'. The general approach is to form portfolios of stocks, where the stocks in each portfolio have different levels of the variable posited to analyze cross-sectional relations. As a nonparametric technique, it does not make any assumptions about the nature of the cross-sectional relations between the variables under investigation.

The steps are as follows:

  1. Calculate periodic (e.g. yearly) breakpoints that will be used to group the entities in the sample into portfolios. The breakpoints are usually determined by percentiles of the sort-variable $X$ at time $t$ of the cross-sectional distribution.
  2. Group all entities in the sample into portfolios. Each time period $t$, all entities in the sample with values of $X$ that are less than or equal to he first breakpoint are put in portfolio one, i.e. the 'low' portfolio. Portfolio two holds entities with values of $X$ that are greater than er equal to the first and less than or equal to the second breakpoint, and so on.
  3. Calculate the equal- or value-weighted return for each portfolio for the subsequent year.
  4. In addition to calculating the average return for each portfolio, you often calculate the return-difference of the high- and low-portfolio, that is a strategy investing long in the highest and short in the lowest portfolio. This difference portfolio is the primary value used to detect a cross-sectional relation between the sort variable and the outcome variable (here: return).

It is common practice, to update the portfolios yearly. If you sort on the 'momentum' variable, monthly reformation is common. For example, Fama/French (1992) form portfolios based on size or book-to-market ratio at the end of June each year and calculate the return for the subsequent year. The formation at the end of June is due to the 'look-ahead-bias', that is to avoid to use accounting data for the previous fiscal-year end, which may not be publicly available until end June of the next year.

Be aware to try exploiting this strategy:

  • Portfolio reformation results in high transaction costs, which may decrease the return significantly.

  • Due to regularization it is often not possible to fully replicate the short-strategy.


References:

Bali/Engle/Murray (2016), Empirical Asset Pricing: The cross-section of stock returns, 1. ed.

Fama/French (1992), The cross-section of expected stock returns, The Journal of Finance.

$\endgroup$
0
$\begingroup$

Related to skoestlmeier's answer, you should also check out https://en.wikipedia.org/wiki/Fama%E2%80%93MacBeth_regression that is precisely the regression to test the strength of a proposed risk factor (= long-short portfolio return)

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.