Portfolio Optimization and Performance Evaluation
Alpha factors generate signals that an algorithmic strategy translates into trades, which, in turn, produce long and short positions. The returns and risk of the resulting portfolio determine the success of the strategy.
To test a strategy prior to implementation under market conditions, we need to simulate the trades that the algorithm would make and verify their performance. Strategy evaluation includes backtesting against historical data to optimize the strategy's parameters and forward-testing to validate the in-sample performance against new, out-of-sample data. The goal is to avoid false discoveries from tailoring a strategy to specific past circumstances.
In a portfolio context, positive asset returns can offset negative price movements. Positive price changes for one asset are more likely to offset losses on another, the lower the correlation between the two positions is. Based on how portfolio risk depends...