The inspiration for this strategy comes from two thesis, Eidenvall, A. (2021). and Baltas, N. (2015). in which we construct a long-short portfolio model based on market regime shift, risk parity and time series momentum. These approaches aim to address some of the limitations of traditional risk parity portfolios.The core logic behind this strategy is to improve upon risk parity, which tends to have lower risk but sacrifices overall returns. Instead, it suggests switching to a lower-risk allocation approach only during periods of significant market volatility, while have higher target risk during normal market conditions, thereby enhancing overall returns.
We adopt the long, short, and target risk parameters and assign different values based on three different market states.When the market is highly dangerous, we reduce most of the long positions, increase short positions and lower the target risk to mitigate downside risks.When the market is moderately dangerous, we reduce some long positions, add a small amount of short positions and use a normal target risk.When the market is in a normal state, we only have long positions without any short positions and use a normal target risk.
By combining these approaches, we aim to enhance the performance and risk management of the portfolio.This strategy is monthly rebalancing with a one-sided trading cost of 0.05% per trade.
The results demonstrate that employing this methodology indeed yields a higher Sharpe ratio compared to equal-weighted portfolios or SPY. It also leads to smaller Maximum Drawdown, comparable annualized returns, and lower market correlation. Overall, by incorporating short positions and market regime shift methods inspired by these two thesis, we have successfully addressed some of the limitations of traditional risk parity approaches and achieved favorable returns.
Quantitative Research Intern, Quantitative Finance, Gamma Paradigm