A pair-wise framework for country asset allocation using similarity ratio

Abstract

We propose a pair-wise strategy to construct country allocation portfolios, based on relative returns forecasts of all asset pairs in the investment universe. As the number of forecasts required is a small fraction of the total number of forecasts generated, it means a good measure of quality would be required to select the best set of forecasts.There is a lack of research and effort in designing a scoring measure that aims to quantify the model quality in terms of directional accuracy. We designed a new distance-based measure called the Similarity Ratio. This measure is innovative, intuitive and emphasizes on directional accuracy and yet able to make use of the magnitudes of the forecasts as tie-breaker. We provide extensive empirical evidences by constructing various country allocation portfolios using the pair-wise framework and Similarity Ratio. The portfolios delivered better risk-adjusted performance than top quartile managers and portfolios constructed using other measures.