Here is a simple checklist to compare different investment strategies. Call it a five-point smell test of what any investor should be looking for when a strategy is being pitched to them.
- Strategy Design - A strategy should be easy to describe to investors. The underlying assumptions should be clear. There should be a strong economic or structural rationale for why the strategy should be successful. Some strategies will only be effective for a limited time, so the manager should be able to explain the conditions when the strategy will fail.
- Expected returns - Defining the expected return goes without saying; however, expected returns should always be tempered by volatility. The Sharpe ratio should be strongly positive but also stable and consistent and reasonable. High risk adjusted returns will not last forever.
- Reliability – All strategies are time varying. The reliability issue is whether it is clear when this variability will occur. What are the conditions for when an investment will do well or poorly? Back-tests are always good, but do they make sense relative to different market conditions.
- Convexity – Every investor wants convexity. It is always an issue of what is the price to be paid for this convexity. In a very broad sense, convexity relative to the market means that when the market is going up, the strategy will also go up and when the market goes down, the strategy will not lose as much as the market. Once that minimum achieved, a great convexity instrument will go up when the market goes down and will have positive correlation when the market is up. This is hard to achieve in reality, but the question has to be asked.
- Costs – There is the cost with implementing a strategy and there is the cost of downside risk. Both of these have to be reviewed and discussed. There is also a cost with liquidity if you are not allowed to exit a strategy or the price of exit is high.