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The APT Part 2 : Avoid Sharp(e) drawdowns !

In this note, we seek to optimize a portfolio allocation using the Serenity Ratio developed in An Alternative Portfolio Theory (APT – Part 1). As a reminder, the Serenity Ratio considers path dependent variables to more accurately measure the drawdown risk of an investment strategy. The higher the Serenity, the better, thus an investor seeks to achieve the highest Serenity possible. However, in the context of a portfolio optimization, we find that the Serenity Ratio lacks predictability: it is a proven ex-post risk indicator to evaluate drawdowns but fails to provide information on potential future deeper drawdowns. Therefore, the Serenity Ratio cannot be used by investors to optimize their portfolio allocation. The second part of this paper focuses on finding a suitable indicator that shows the same properties as the Serenity Ratio (later called proxy) which could be used in a portfolio allocation and help limit the drawdown risk. To do so, we analyze the drivers of drawdowns and we find several explanatory variables, including autocorrelation of returns. We conclude by finding a good proxy that accounts for these variables which has a stronger predictive power than the Serenity Ratio while providing better results in minimizing drawdowns.

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