The Goldman Sachs re-balanced Sharpe Ratio portfolio continues to outperform through a formula that considers future valuations and avoids the emotion and market chatter.
Stock selection modification is done by modifying Sharpe Ratio
The Goldman Sachs method to modify to select stocks is done by modifying the traditional Sharpe Ratio, a measure of risk and reward that measures upside and downside volatility to determine a risk reward profile of an investment. Goldman’s modification to traditional use of the Sharpe Ratio is not as radical as many have proposed. Instead of providing a different risk weighting to upside deviation than downside deviation, the financial engineers at Goldman consider the top 50 stocks in the S&P 500 with the highest “prospective Sharpe Ratio.” This means the venerable investment bank is betting on the future of a stock’s Sharpe Ratio – and the strategy has performed.
In five years since inception, Goldman reports the strategy beats the S&P 500 (INDEXSP:.INX) by 27 percent. Since December 2013, when the portfolio was re-adjusted, the strategy has outperformed the S&P 500 again, delivering 12.55 percent vs 10%.
In its US Weekly Kickstart publication, the pitch is clear. “Investors frustrated with the current low volatility, low dispersion environment should look to our Sharpe Ratio strategy (Bloomberg: GSTHSHRP),” the newsletter says, looking for investors willing to think outside the box.
What is the secret behind delivered returns?
Taken at face value the strategy has delivered returns. The question is: what’s the secret?
Goldman tweeks the old Sharpe Ratio formula by considering not the current earnings, but expected earnings, and plugging this into the stock selection mix without any additional filters. Considering consensus expected returns, it models this alongside standard option volatility and, vola! The strategy selects the top stocks that should perform for the next six months. Every six months the selection rotates, delivering new pics. The latest version, for example, contains 38 new stocks, which is slightly above their average turnover but nonetheless indicates this strategy is about picking the short term, six month performers and rotating out.
The stock selection strategy isn’t targeting specific categories, but just lets the stocks fall into place naturally. Some of their more interesting picks includes beaten down stocks such as General Motors Company (NYSE:GM), Citigroup Inc (NYSE:C), E TRADE Financial Corporation (NASDAQ:ETFC), The Coca-Cola Company (NYSE:KO), The Boeing Company (NYSE:BA), eBay Inc (NASDAQ:EBAY) and salesforce.com, inc. (NYSE:CRM).
Perhaps what is most interesting about the strategy is how it ignores the emotion of the street. Many of the stocks in the portfolio are in the news for one scandal or another. In one respect, this Goldman stock selection method doesn’t consider the scandal – just the raw, emotionless numbers that say, strictly on a valuation standpoint, these are stocks worth owning at this very moment in time.