Monday, June 26, 2017

Position sizing, expected return, and portfolio results - There is imprecision in trader language

"I only take trades that have an expected return to risk of 3:1 and my average risk position .5 to 1.5% based on my conviction. I expect to generate mid-teens returns with a 10% vol..... bla, bla, bla...." 
This is pretty standard language for many traders describing their strategy, but some of it does not make sense when you look through the numbers, or at least a careful look at the numbers will tell you what has to happen for this all to be true. 
This is where simple cases of imprecise language can lead to confusion. Investors may have problems with understanding what a trader means if all the assumptions concerning trading are not well-defined. Here are some questions that an investor may have when hearing the above phrases.
  • If you only take 3:1 return to risk trades and your volatility is 10%, then does this mean your return should be 30%? 
    • The idea of risk and return for a trade have to be made precise.
  • If you only generate a 10% return in reality, does this mean that 2/3rds of your trades scratched with no gain?
    • An ex ante 3:1 trade is not the same as ex post returns. 
  • Does it mean that your 3:1 trades were actually only 1:1 trades? 
    • The translation from trades to portfolio returns is not always easy to describe.
  • How many losing trades did you have? 
    • 3:1 trades only give you half the story. Investors need to know the outcomes. 
  • How many winners were there of those original trades?
  • If ex ante you expect 3:1 trades, what is your success ex post?
    • I might prefer 2:1 if your success rate is better.
  • If your average risk position is between .5 and 1.5%, you have to come up with a lot of good 3:1 trades to make money. How many "3-baggers" are out there?
    • How many good ideas can one trader come up with in one year if you will only take 1% risk per trade?
  • Assume you take 1% positions; if you take 100 position, you will need a fair number of successful trades to hit anything close to a 10% return. How much are you willing to lose for those 3:1 trades?
  • How long will you wait for those 3:1 trades to be realized? 
    • 3:1 trade over different time frames makes a huge difference in returns. 
Using the fundamental law of active management, what does it mean when you say you take 3:1 trades? How many trades do you actually have to take? The fundamental law states that the information ratio is equal to the information coefficient or selection skill times the square root of the number of investment opportunities. Efficiency, the information ratio, is equal to skill times breath. A trader needs a lot of independent trades to make money independent of a benchmark.
Obviously, this original comment can be decomposed and carefully studied to show the potential returns under a number of alternatives. Our important point is to focus on the ambiguity and imprecision of language when these terms are used. Don't take what is said for granted. 

Saturday, June 24, 2017

Mixing collateral with a managed futures portfolio - Need to know marginal contributions

In an earlier post we discussed the issue of using capital more efficiently in a managed futures investment. The premise is simple. If only limited funds are used for margin, the majority of cash associated with a managed futures investment are held in low interest investments. This portion of the managed futures capital can be better deployed to increase returns. Similarly, managed futures can be used as an overlay to an existing portfolio to better use cash. See "Use your collateral wisely and enhance managed futures efficiency".

In this post, we use a simple example to look at the trade-off of risk and return when using the collateral more efficiently. We take a simple combination of two assets, the managed futures portfolio and the cash portfolio which we have set at 80% of the funds invested. Our example starts with a managed futures fund that has a 10% volatility in the table below. With the collateral investment in cash, the marginal increase in volatility is zero, so the volatility of the fund is just the risk associated with managed futures trading positions.

Any movement of funds away from cash will be affected by the volatility of the investment and the correlation between the managed futures trade portfolio and the collateral investment. We can first determine the volatility of the overall portfolio when there is an investment in a trading account and an alternative cash account. From this number we can subtract the volatility of the portfolio that just holds cash for collateral. This will tell us the marginal increase in risk from holding alternatives to cash at different volatility and correlation combinations. This matrix can be changed to a smaller investment of collateral to, say 40%. In that case, the marginal change in volatility will be lower as well as the increase in return.

If you invest collateral in a negatively correlated asset, there will be a decrease in overall volatility. If there is an asset that is liquid and can be negatively correlated with the trading account, the fund volatility can be decreased and returns can be increased to improve the fund information ratio. If there is an expected return from the collateral investment, the investor can determine what is the volatility and correlation combination necessary to have a positive marginal information ratio. This post shows that collateral management can be analyzed in a systematic manner in order to explore issues of fund capital efficiency. 

Friday, June 23, 2017

Northern Trust - EIU Survey - "See" the risk - "Know" the risk

The Northern Trust/EIU Transparency in Alternatives Investing Survey 2017 focuses on some important investment considerations from investors around the world. Once again the most important issue seems to be the degree of transparency provided by managers. This applies to both traditional and alternative managers. An investor needs to know what he is buying when he gives money to a manager. Funds are entrusted to others. The purpose for this transparency is very clear - understanding the degree of risk being taken. 

Transparency on a simple level means information. Investors want to know the contents of the portfolio and the foundation of the investment process or style, but the degree of risk is more complex issue. You may have the information, but you may not know the actual risks within the portfolio. The true demand of investors is with interpreting the data. What are types of risk being taken? What are the risk premiums being exploited? How will the portfolio react to changes in the investment environment? Transparency is more than information but clarity with the expected behavior of the manager and the types of risks hidden when securities are aggregated in a portfolio. 

Wednesday, June 21, 2017

Use your collateral wisely and enhance managed futures efficiency

Managed futures investments have the key structural feature that they do not use leverage in the sense of borrowing money to increase notional positions relative to cash. In most cases, margin requirements are a small fraction of the capital invested in a program or fund. A managed futures fund may only use less than 20 cents on the dollar for margin while 80 cents or more may be held in a custody account at close to zero interest rate. Nevertheless, some managers are more aggressive and may hold funds in an enhanced money fund or short-term bond fund to add to return. Of course, some investor will use a separate account and only provide funds for margin with a cushion.  This cuts the excess cash held by the manager. 

Generally, capital is not used efficiently with this hedge fund strategy. By efficiency we mean that returns can be enhanced by deploying more of the money in the fund in investments that have a return higher than cash. This will have an impact on overall volatility, but this can be managed to still target a specific volatility level for the fund.

A simple way of more efficiently using the capital is to employ managed futures as a overlay program so that all of a portfolio's capital is used to generated the highest returns possible. The notional trading size of the overall portfolio will be higher, but the volatility of the overall portfolio can still be managed to specific volatility target.

There is both potential benefits and costs with using the capital that is held in cash based on the correlation between the managed futures program and the choice of investment for the non-margin funds. If the funds are held in an asset or strategy that has higher volatility than cash, the net result may be an increase in the overall volatility of the fund. The portfolio volatility will be based on the combination of the volatility for the cash component and the correlation with the futures program. An investor may not want to pay for the higher volatility or return that is not associated with this use of the cash; however, that is an issue of negotiation between the manager and the investors. 

The cash component decision can be thought of as a continuum of risk and return with the base position being cash which has no correlation with the managed futures returns and has limited or no return. The manager or investor can move out the risk spectrum for the collateral usage. However, the impact on overall volatility will be related to the correlation between the collateral account and the managed futures program. If there is a negative correlation, the enhanced collateral may actually reduce overall program risk. 

The choice set of how to employ managed futures and efficiently use capital is fairly broad but can help widen the return opportunities for both manager and investor. Holding cash may be the best alternative but that decision should be made after looking at all of the choices for excess collateral.