Sectoral portfolio optimization by judicious selection of financial ratios via PCA

Abstract: Embedding value investment in portfolio optimization models has always been a challenge. In this paper, we attempt to incorporate it by employing principal component analysis to filter out dominant financial ratios from each sector and thereafter, use the portfolio optimization model incorporating second-order stochastic dominance criteria to derive an optimal investment. We consider a total of $11$ financial ratios corresponding to each sector representing four categories of ratios, namely liquidity, solvency, profitability, and valuation. PCA is then applied over a period of 10 years to extract dominant ratios from each sector in two ways, one from the component solution and the other from each category on the basis of their communalities. The two-step Sectoral Portfolio Optimization (SPO) model is then utilized to build an optimal portfolio. The strategy formed using the formerly extracted ratios is termed PCA-SPO(A) and the latter PCA-SPO(B). The results obtained from the proposed strategies are compared with those from mean-variance, minimum variance, SPO, and nominal SSD models, with and without financial ratios. The empirical performance of proposed strategies is analyzed in two ways, viz., using a rolling window scheme and using market trend scenarios for S&P BSE 500 (India) and S&P 500 (U.S.) markets. We observe that the proposed strategy PCA-SPO(B) outperforms all other models in terms of downside deviation, CVaR, VaR, Sortino, Rachev, and STARR ratios over almost all out-of-sample periods. This highlights the importance of value investment where ratios are carefully selected and embedded quantitatively in portfolio selection process.