There were a few statements in my last post that needed more substance.
The following chart depicts a portfolio equally invested in 11 sectors, each with their respective compounding rates of return.
Fig. 1 Sector Contribution to Overall Portfolio Performance
The chart is simple. The sums follow the first equation in my previous post. Initially, $10M is distributed equally to 11 sectors. Each displayed in decreasing order of their equivalent long-term average compounding rate of return. We easily observe that the highest contributions to the total portfolio's performance came from the few with the highest compounding rates. One would have to say: evidently. And that is the point. Evidently.
If, instead, you distributed the initial capital to the top 5 sectors only, you would get something like the following chart:
Fig. 2 Top Sector Contribution to Portfolio Performance
The sector's CAGR were not changed. Nonetheless, each sector contributed more to the portfolio. The reason is simple, they were allocated more capital (120% more). Not new capital since all of it was coming from the abandoned sectors. Compounding did its thing. By moving the capital to the top 5 sectors it improved overall performance for the presented model by some 71.9%.
This should not stop someone from including the best stock performers from the abandoned sectors. If any of them tended to outperform even the lowest of the top performers they could also be considered as available trading candidates for your portfolio. Neither should it stop you from designing whatever trading strategy you want. It is always your game and you play it like you want to play it. Common sense should still prevail.
Since we can identify the top sectors for extended periods of time (this was demonstrated in a prior post), one could allocate more to the best performers of the group as depicted in the following chart:
Fig. 3 Top Sector Enhanced Contribution to Performance
Making such a move improved performance by 100%. Note that in each selected sector, only the top performing stocks should be chosen which in turn will improve overall performance even further.
What was presented is the long side of the problem. It said to enhance performance, select the best-performing stocks in the best performing sectors. Automatically, you will be performing better than market averages.
Doing the same thing for a $50 million portfolio will show a dramatic improvement.
Fig. 4 Top Sectors, Enhanced Contribution, $50 Million Initial Capital
Building along these lines can only improve your trading strategy's outcome, whatever it is.
What is proposed did not change the architecture, structure or underlying philosophy of a trading program. Nonetheless, it did change the strategy's behavior and how it should weight its alternatives.
It becomes an opportunity cost to not do something when you know what could be done. Take the outcome of the first chart and compare it to the one above. Amazing what compounding can do.
What I think strategy developers should do is find ways to increase overall portfolio performance, even if it was by only 2-alpha points. The value of those 2-alpha points above market averages is considerable since the alpha is also part of compounding. To gain an idea of the value of those 2 percentage points, simply compare the chart below to the preceding one, or to the first one, whichever you prefer.
Fig. 5 Top Sectors, Enhanced Plus 2-Alpha Points, $50 Million
Doing ordinary, meaning doing no more than the averages is of little interest. That stuff can be had by so many other means. Buying an index fund would do the job.
If you have the talent, then differentiate yourself. Show that you can get those 2 extra alpha points above averages. It would be more than sufficiently rewarding for all involved. If you can do even better, then go for it.
Adding a zero to the initial capital would generate ten times the above scenario (Fig. 5). All of it could be due to the single trading script you designed. Think big was part of the 70's culture. Maybe time to bring it back.
What was presented is kind of generic. It does apply to sectors, and is pervasive throughout all aspects of portfolio management. That it be sectors, industries, stocks, strategies, portfolios, portfolios of strategies, or funds of portfolios of strategies; they all can be ordered by outcomes. And doing this will generate tables like those shown above. Enhancing the best performers in all those groups will tend to increase overall performance.