Multi-period portfolio optimization with alpha decay

This research paper appeared in  The International Journal of Financial Engineering and Risk Management  Special Issue on Applications of Optimization in Finance.

The traditional Markowitz MVO approach is based on a single-period model. Single period models do not utilize any data or decisions beyond the rebalancing time horizon with the result that their policies are "myopic" in nature. For long-term investors, multi-period optimization offers the opportunity to make "wait-and-see" policy decisions by including approximate forecasts and long-term policy decisions beyond the rebalancing time horizon. We consider portfolio optimization with a composite alpha signal that is composed of a short-term signal that has a high IC but decays rapidly, and a long-term alpha signal that has lower IC but more persistence. We develop a simple two stage multi-period model that incorporates this alpha model to construct the optimal portfolio at the end of the rebalancing period. We compare this model with the traditional single-period MVO model and show that the multi-period model generates portfolios that are likely to have a better realized performance.