**Systematic Investor » R**, and kindly contributed to R-bloggers)

The Omega Ratio was introduced by Keating and Shadwick in 2002. It measures the ratio of average portfolio wins over average portfolio losses for a given target return L.

Let x.i, i= 1,…,n be weights of instruments in the portfolio. We suppose that j= 1,…,T scenarios of returns with equal probabilities are available. I will use historical assets returns as scenarios. Let us denote by r.ij the return of i-th asset in the scenario j. The portfolio’s Omega Ratio can be written as

I will use methods presented in Optimizing Omega by H. Mausser, D. Saunders, L. Seco (2006) paper to construct optimal portfolios that maximize Omega Ratio.

The maximization problem (pages 5-6) can be written as

It can be formulated as a linear programming problem with following transformation

This method will only work for . In the case , I will use a Nonlinear programming solver, Rdonlp2, which is based on donlp2 routine developed and copyright by Prof. Dr. Peter Spellucci. Following code might not properly execute on your computer because Rdonlp2 is only available for R version 2.9 or below.

max.omega.portfolio <- function ( ia, # input assumptions constraints # constraints ) { n = ia$n nt = nrow(ia$hist.returns) constraints0 = constraints omega = ia$parameters.omega #-------------------------------------------------------------------------- # Linear Programming, Omega > 1, Case #-------------------------------------------------------------------------- # objective : Omega # [ SUM <over j> 1/T * u.j ] f.obj = c(rep(0, n), (1/nt) * rep(1, nt), rep(0, nt), 0) # adjust constraints, add u.j, d.j, t constraints = add.variables(2*nt + 1, constraints, lb = c(rep(0,2*nt),-Inf)) # Transformation for inequalities # Aw < b => Aw1 - bt < 0 constraints$A[n + 2*nt + 1, ] = -constraints$b constraints$b[] = 0 # Transformation for Lower/Upper bounds, use same transformation index = which( constraints$ub[1:n] < +Inf ) if( len(index) > 0 ) { a = rbind( diag(n), matrix(0, 2*nt, n), -constraints$ub[1:n]) constraints = add.constraints(a[, index], rep(0, len(index)), '<=', constraints) } index = which( constraints$lb[1:n] > -Inf ) if( len(index) > 0 ) { a = rbind( diag(n), matrix(0, 2*nt, n), -constraints$lb[1:n]) constraints = add.constraints(a[, index], rep(0, len(index)), '>=', constraints) } constraints$lb[1:n] = -Inf constraints$ub[1:n] = Inf # [ SUM <over i> r.ij * x.i ] - u.j + d.j - L * t = 0, for each j = 1,...,T a = rbind( matrix(0, n, nt), -diag(nt), diag(nt), -omega) a[1 : n, ] = t(ia$hist.returns) constraints = add.constraints(a, rep(0, nt), '=', constraints) # [ SUM <over j> 1/T * d.j ] = 1 constraints = add.constraints(c( rep(0,n), rep(0,nt), (1/nt) * rep(1,nt), 0), 1, '=', constraints) # setup linear programming f.con = constraints$A f.dir = c(rep('=', constraints$meq), rep('>=', len(constraints$b) - constraints$meq)) f.rhs = constraints$b # find optimal solution x = NA sol = try(solve.LP.bounds('max', f.obj, t(f.con), f.dir, f.rhs, lb = constraints$lb, ub = constraints$ub), TRUE) if(!inherits(sol, 'try-error')) { x0 = sol$solution[1:n] u = sol$solution[(1+n):(n+nt)] d = sol$solution[(n+nt+1):(n+2*nt)] t = sol$solution[(n+2*nt+1):(n+2*nt+1)] # Reverse Transformation x = x0/t } #-------------------------------------------------------------------------- # NonLinear Programming, Omega > 1, Case #-------------------------------------------------------------------------- # Check if any u.j * d.j != 0 or LP solver encounter an error if( any( u*d != 0 ) || sol$status !=0 ) { require(Rdonlp2) constraints = constraints0 # compute omega ratio fn <- function(x){ portfolio.returns = x %*% t(ia$hist.returns) mean(pmax(portfolio.returns - omega,0)) / mean(pmax(omega - portfolio.returns,0)) } # control structure, fnscale - set -1 for maximization cntl <- donlp2.control(silent = T, fnscale = -1, iterma =10000, nstep = 100, epsx = 1e-10) # lower/upper bounds par.l = constraints$lb par.u = constraints$ub # intial guess if(!is.null(constraints$x0)) p = constraints$x0 # linear constraints A = t(constraints$A) lin.l = constraints$b lin.u = constraints$b lin.u[ -c(1:constraints$meq) ] = +Inf # find solution sol = donlp2(p, fn, par.lower=par.l, par.upper=par.u, A=A, lin.u=lin.u, lin.l=lin.l, control=cntl) x = sol$par } return( x ) }

First let’s examine how the traditional mean-variance efficient frontier looks like in the Omega Ratio framework.

# load Systematic Investor Toolbox setInternet2(TRUE) source(gzcon(url('https://github.com/systematicinvestor/SIT/raw/master/sit.gz', 'rb'))) #-------------------------------------------------------------------------- # Create Efficient Frontier #-------------------------------------------------------------------------- ia = aa.test.create.ia() n = ia$n # 0 <= x.i <= 0.8 constraints = new.constraints(n, lb = 0, ub = 0.8) # SUM x.i = 1 constraints = add.constraints(rep(1, n), 1, type = '=', constraints) # Omega - http://en.wikipedia.org/wiki/Omega_ratio ia$parameters.omega = 13/100 ia$parameters.omega = 12/100 # convert annual to monthly ia$parameters.omega = ia$parameters.omega / 12 # create efficient frontier(s) ef.risk = portopt(ia, constraints, 50, 'Risk') # Plot Omega Efficient Frontiers and Transition Maps layout( matrix(1:4, nrow = 2, byrow=T) ) # weights rownames(ef.risk$weight) = paste('Risk','weight',1:50,sep='_') plot.omega(ef.risk$weight, ia) # assets temp = diag(n) rownames(temp) = ia$symbols plot.omega(temp, ia) # mean-variance efficient frontier in the Omega Ratio framework plot.ef(ia, list(ef.risk), portfolio.omega, T, T)

Portfolio returns and Portfolio Omega Ratio are monotonically increasing as we move along the traditional mean-variance efficient frontier in the Omega Ratio framework. The least risky portfolios (Risk_weight_1, Risk_weight_10) have lower Omega Ratio for 13% threshold (target return) and the most risky portfolios (Risk_weight_40, Risk_weight_50) have higher Omega Ratio.

To create efficient frontier in the Omega Ratio framework, I propose first to compute range of returns in the mean-variance framework. Next split this range into # Portfolios equally spaced points. For each point, I propose to find portfolio that has expected return less than given point’s expected return and maximum Omega Ratio.

#-------------------------------------------------------------------------- # Create Efficient Frontier in Omega Ratio framework #-------------------------------------------------------------------------- # Create maximum Omega Efficient Frontier ef.omega = portopt.omega(ia, constraints, 50, 'Omega') # Plot Omega Efficient Frontiers and Transition Maps layout( matrix(1:4, nrow = 2, byrow=T) ) # weights plot.omega(ef.risk$weight, ia) # weights rownames(ef.omega$weight) = paste('Omega','weight',1:50,sep='_') plot.omega(ef.omega$weight, ia) # portfolio plot.ef(ia, list(ef.omega, ef.risk), portfolio.omega, T, T)

The Omega Ratio efficient frontier looks similar to the traditional mean-variance efficient frontier for expected returns greater than 13% threshold (target return). However, there is a big shift in allocation and increase in Omega Ratio for portfolios with expected returns less than 13% threshold.

The Omega Ratio efficient frontier looks very inefficient in the Risk framework for portfolios with expected returns less than 13% threshold. But remember that goal of this optimization was to find portfolios that maximize Omega Ratio for given user constraints. Overall I find results a bit radical for portfolios with expected returns less than 13% threshold, and this results defiantly call for more investigation.

To view the complete source code for this example, please have a look at the aa.omega.test() function in aa.test.r at github.

**leave a comment**for the author, please follow the link and comment on his blog:

**Systematic Investor » R**.

R-bloggers.com offers

**daily e-mail updates**about R news and tutorials on topics such as: visualization (ggplot2, Boxplots, maps, animation), programming (RStudio, Sweave, LaTeX, SQL, Eclipse, git, hadoop, Web Scraping) statistics (regression, PCA, time series, trading) and more...