Quote from McBet:
If your goal is improved prediction of the correlation matrix between assets (here: systems), then why not keep it even more robust than non-parametrics... I doubt if we should try to beat the naive weighting scheme... in-sample gains can be propagated by momentum but eventually the overallocation errors will catch up with us, once the profits of our historically best systems revert to the mean...
I don't know that I understand "the naive weighting scheme." I have seen a variety: margin weighting, volatility weighting, stop-loss % of trading account, ...
Yes, one wishes to understand the system-market combination. (If a system is a pair-trading system, it is the combination of the system and the pair of markets.)
I agree with you that the the performance of the system-market combination should not be chased blindly as it is a trailing indicator.
For me, the main thing is the correlation of the underlying markets. If I have a system which wants to buy Euro futures and a system which wants to sell Swiss Franc futures, then I can get more contracts with the same risk than if it had been buy-buy or sell-sell.
The principle purpose for keeping a performance metric in a Portfolio Allocation scheme, IMHO, it to objectively weed-out non-performers. It is too easy to backtest 100 markets, and then publish an allocation on the top 4. I would want to know that my market selection did not unduly bias my results. (Unfortunately, showing all 100 tends to confuse prospective investors, but knowing that you have done things honestly means that you can safely bring-up the topic when productive.)
The place that Modern Portfolio Theory gets complicated is that one needs money management constraints to make it real.
Here are things that I find relevant:
Current Positions
Likelihood that a combination will enter today
Transaction Cost Estimates
Maximal Position Size per combination (Vol %, OI %)
Expected return per combination (this is where both historical performance and current market conditions enter)
Forecast market volatility
Forecast market correlation
Is Rebalancing allowed today?
Target Portfolio Volatility
Maximum Allowed Margin
Are non Synergistic Trade Allowed?
Modern methods can do a good job of forecasting the size of the market return (if not direction), market volatility and market correlation. If you stick to systems that hold positions at least a few days, then this tells you system-market correlation and volatility.
The biggest negatives to sophisticated Portfolio Allocation are that the costs of rebalancing can be high, that the market model can be unrealistic, and that trading more markets is more error prone. If you can nail these issues down, your drawdown and especially the volatility of your portfolio balance should go way down even with fairly modest systems.
Having a real Portfolio Allocation system in place allows us to replay historical stress periods. Of course ones worst day is always in the futures.
The electric company can't be sure we won't all turn on our vacuum cleaners together, but the measured affect is that our house voltage stays within a small range. Probability/statistics does work.
