Application of Maximum Sharpe Ratio and Minimum Variance Portfolio Optimization for Industries

Abstract

Since the start of 2022, expectations regarding the continuous raising of interest rates by the Fed to curb the 40-year-high inflation has been negatively impacting the US stock market, leading to volatility spikes. Thus, portfolio optimization plays an important role to risk-averse investors. This paper investigated an optimal portfolio strategy that aims to maximize the Sharpe ratio to outperform a common benchmark, the S&P500. Eleven US stocks were selected, one from each of the eleven market sectors, based on market capitalization. Then, mean-variance portfolio optimization was conducted to obtain an optimal distribution of stocks weighing in Maximum Sharpe Ratio Portfolio (MSRP) and Global Minimum Variance Portfolio (GMVP), and backtesting was adopted to construct portfolio performance for MSRP, GMVP and Equal-Weight Portfolio (1/N) strategies by using historical data from the first eight months of 2022. The Sharpe ratio was calculated to compare the performance between the three strategies---MSRP, GMVP and 1/N---and the S&P500. Empirical results, supported by a robustness test, suggested that MSRP strategy outperformed S&P500 with the highest Sharpe ratio, which indicated that MSRP achieved a higher return per unit of risk regardless of market volatility presented in different time intervals. Therefore, this research provides insights into portfolio investment decision-making for risk-averse investors.