Sherman ratio optimization: constructing alternative ultrashort sovereign bond portfolios

Karim Henide

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As an alternative to μ−σ optimisation and conditional prediction models in fixed income, we explore a pragmatic and scalable approach to constructing ultra-short bond collateral portfolios.
Our approach disregards constituents’ covariance, and is thus unencumbered by the issue of model instability which the problématique setting is susceptible to.
We invoke the eponymous Sherman ratio as our objective function, which we linearly optimise our benchmark duration-matched portfolio weights around; the study is reiterated for different levels of issuer capping.
We find that unconstrained Sherman optimal portfolios contribute to an average of 17.8 bps of option-adjusted yield to portfolios held-to-maturity over the study window and contribute additively to collateral portfolios’ information ratio, albeit provoking a high degree of portfolio turnover in the latter where portfolios are rebalanced monthly.

Abstract

We construct duration-matched portfolios from the universe of the ICE BoA 0–2 Year AAA Euro Government Index (the “benchmark”), reweighted to optimize the portfolio Sherman ratio. We assess the potential of a hold-to-maturity strategy to maximize nominal portfolio yield and of a dynamic strategy to deliver superior total return performance, with both strategies maintaining an identical duration exposure to the benchmark among otherwise virtually homogenous risk exposures. Our findings suggest there is merit to Sherman ratio optimization in portfolio construction. In addition, combining Sherman ratio optimization with constraints on individual bond weights provides a lever for retilting the strategy’s risk–return profile to align with investor utility.

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