Net Long Portfolio Risk Analyses

In Chapter 8 , we created net long portfolios (with weights that add up to one) comprised of the global minimum variance portfolio G plus a number of long-short portfolios. Portfolio G was developed in Chapter 7 using the ZCAPM, a new asset pricing model developed by Kolari et al. (A new model of capital asset prices: Theory and evidence. Palgrave Macmillan, Cham, Switzerland, 2021). The long-short portfolios are based on different levels of zeta risk (associated with market return dispersion)Market return dispersion as estimated by the ZCAPM. The returns and risks of these net long portfolios traced out an empirically efficient frontierEmpirical efficient frontier that looked like the theoretical efficient frontier of Markowitz’s (Journal of Finance 7:77–91, 1952, Portfolio selection: Efficient diversification of investments. John Wiley & Sons, New York, NY, 1959) mean-variance investment parabolaMean-variance investment parabola. Strikingly, in the analysis period from July 1964 to December 2022, some net long portfolios yielded out-of-sample average returns in the next month of 30% or more. Subperiod analyses confirmed these findings with some decrease in average returns in the second half of the analysis period due to general market conditions. Sharpe ratios further corroborated the results that tended to increase with the zeta risk of the net long portfolios. Referring to graphs of average stock returns and total riskTotal risk, the CRSP market index was located in the vicinity of the axis of symmetry of the mean-variance parabola. The result is consistent with ZCAPM theory, which hypothesizes that average market returns lie on the axis of symmetry of the parabola. Thus, ZCAPM theory is supported. Additional evidence showed that Sharpe ratios of net long portfolios well exceed the CRSP index and tend to increase as zeta risk in the long-short portfolios increase. These findings further support the ZCAPM, which hypothesizes that zeta risk related to market return dispersionMarket return dispersion can be used to boost average portfolio returns. Although the performance of our ZCAPM-based net long portfolios was outstanding by any standards for well-diversified portfolios, a natural question that arises is: What are the risk characteristics of the portfolios? Investment managers and their clients need to have realistic expectations not only about the returns but risks of their investments. In this way, the return/risk preferences of investors can be aligned by managers to meet their needs. In this chapter we apply risk metrics discussed in Chapter 6 to the net long portfolios, including the Gibbons, Ross, and Shanken (GRS) (Econometrica 57: 1121–1152, 1989) test for efficient portfoliosEfficient portfolio involving the Sharpe ratio, value at risk (VaR), and drawdowns. As we will see, most net long portfolios have good risk characteristics that recommend their real world implementation for investors. The next section covers GRS tests of the net long portfolios. Subsequent sections address VaRs and drawdowns, respectively.