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Jun 3

Constructing 130/30 Portfolios with the Omega Ratio

Posted by abiao at 13:01 | Paper Review | Comments(1) | Reads(16103)
Constructing 130/30-Portfolios with the Omega ratio is an interesting paper forthcoming in Journal of Asset Management by Gilli, Manfred, Schumann, Enrico, Di Tollo, Giacomo and Cabej, Gerda. Typical portfolio construction theory uses Markowitz efficient frontier under mean-variance framework to find an optimized portfolio, the authors in this paper construct portfolios with an alternative selection criterion, the Omega function.

Any portfolio return r can be decomposed into
omega function return
define the downside and upside partial moments as follows
omega function downside, upside partial moments
our objective is to minimize the below Omega ratio, a known performance measure, subject to additional constraints such as long short weights.
omega function

The authors apply this method to their data and conclude: the Omega function selected well-performing portfolios in terms of final wealth. These portfolios, however, exhibited a higher volatility when compared with naive mean variance method. Also the Omega-portfolios exhibited a favorable asymmetry in returns, and generally thinner tails than mean-variance-portfolios.

For detail please refer to the original paper downloadable at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1464798.

Here's a tutorial that explains how you can maximize the Omega Ratio of a portfolio of three stocks using Excel. It's a simplified problem because Excel's optimizers are not robust enough for more complex applications under realistic business conditions.
Maximize Omega Ratio
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