Magic formula combined with long/short portfolio optimization

Abstract

The Magic Formula is a two factor value investing model, specialized in finding underpriced low risk investment opportunities. This study extends available data until 2015 on the ability for the Magic Formula to rank companies and beat the market. In the updated book the formula delivers 15.2% annualized returns in the period 1988–2009, when investing in the top decile of the largest 2500 companies in the U.S. This thesis finds that the Magic Formula generates 21.6% when invested in decile 1, a result that increases to 24.7% when investing in a 110/10 Market-Neutral Long/Short Portfolio. Long/short value investing gives a lower standard deviation and allows for a better sharpe ratio.