Linear Trading Rules for Portfolio Management

Abstract

The author develops a workable procedure to make quantitative portfolio management more dynamic. Under several simplifying assumptions, an optimal portfolio management policy can be described by a linear trading rule in which the manager moves part of the way from the current position toward a target position. The author views the linear trading rule as the entry to the dynamic portfolio management space. A linear trading rule for one asset is governed by a parameter called the trade rate. The trade rate controls the rate of trading and the weight given to the sources of alpha for that asset. With the trade rate, one can calculate expectations of risk, transactions costs, turnover, and the asset’s exposure to the sources of alpha. This leads to a choice of each asset’s trade rate to maximize that asset’s contribution to an overall objective. This, in turn, yields transactions cost–sensitive signal weighting at the asset level. Finally, the knowledge gained provides a dynamic component to more traditional single or multistage portfolio optimization.

TOPICS: Portfolio theory, portfolio management/multi-asset allocation