Portfolio optimizer software is a tool used by investment professionals to test the risk and return characteristics of their portfolios on historical data. This article discusses the benefits and myths of these types of tools on real world investment returns.
Mutual fund managers, hedge fund managers, and wealth managers are all judged on the real performance of their managed portfolios over time. This is typically compared to a major benchmark such as the S&P500, MSCI World Index, High Yield Bond Index, or other well-known diversified measure.
The goal is to outperform the benchmark consistently. This can be done by generating the same returns with less risk, greater returns with more risk, or more returns with less risk. The optimum theoretical investment portfolio lies on something called the Efficient Frontier. So how do investment managers build a portfolio that performs at its best?
After picking the best investments, a fund manager will turn to portfolio optimizer software to determine the optimum weightings for each stock, bond, or ETF. Plugging in the list of possible investments and running multiple simulations will output an estimated optimum portfolio based on the historical correlations, volatilities, and returns of each one. The primary benefit of this process is to understand if the portfolio has sufficient diversification. It is easy to accidentally create a portfolio which is highly correlated and vulnerable to market shocks and this simulation analysis is helpful in reducing this danger.
While the process itself is informative, beware that it’s not perfect and can lead to some erroneous assumptions. It’s based on historical data only and tomorrow may not be the same as the past, so today’s portfolio will not be the optimum one for the future. It assumes no transaction costs which is clearly not the case. It assumes perfect information is available in the market which may or may not be true. Finally, it is based on the belief that a major market index is the most appropriate benchmark when many investors may have other drivers such as tax rates, hedging, or a specific investment time horizon.
This short overview of portfolio optimizer software and its common usage should help you determine if this type of tool is right for you.
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