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  • Alpha Theory Differentiation From Portfolio Op Tim Ization

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    Fundamental versus Traditional Portfolio Optimization  Alpha Theory enforces a discipline upon a firm’s decision process (position selection, sizing, and trading) by creating an  investment process based on risk‐adjusted return.  Alpha Theory then scales position sizes depending on the magnitude  of the risk‐adjusted return (ie. higher risk‐adjusted return equals a larger position size) to maximize the risk‐adjusted  return of the portfolio.  Portfolio Optimization (Risk Management) Tools use Modern Portfolio Theory, specifically Markowitz mean‐variance, to  ensure that the portfolio resides on the Efficient Frontier.  Additional measures like Value at Risk (VAR) and proprietary  statistics tools are folded into the optimization equation to maximize the return of the portfolio.  Traditional Portfolio Optimization is well suited for quantitative managers but not designed for the deep research of  fundamental asset managers.  The primary difference is how each measures return and risk.    Return.  Alpha Theory measures return by taking the analyst’s calculation of risk‐adjusted return.  Most Traditional  Portfolio Optimization tools use historical returns as an indicator of future returns.  Others use more realistic return  estimators that are defined by the user, but still do not incorporate scenario analyses like Alpha Theory.   In addition, we have proven through Monte Carlo simulation that Alpha Theory is the superior method for maximizing  portfolio expected return.  Markowitz mean‐variance does not beat equal weighting as a position sizing method and  Alpha Theory beats equal weighting by almost 80%. 

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    Fundamental versus Traditional Portfolio Optimization  Alpha Theory enforces a discipline upon a firm’s decision process (position selection, sizing, and trading) by creating an  investment process based on risk‐adjusted return.  Alpha Theory then scales position sizes depending on the magnitude  of the risk‐adjusted return (ie. higher risk‐adjusted return equals a larger position size) to maximize the risk‐adjusted  return of the portfolio.  Portfolio Optimization (Risk Management) Tools use Modern Portfolio Theory, specifically Markowitz mean‐variance, to  ensure that the portfolio resides on the Efficient Frontier.  Additional measures like Value at Risk (VAR) and proprietary  statistics tools are folded into the optimization equation to maximize the return of the portfolio.  Traditional Portfolio Optimization is well suited for quantitative managers but not designed for the deep research of  fundamental asset managers.  The primary difference is how each measures return and risk.    Return.  Alpha Theory measures return by taking the analyst’s calculation of risk‐adjusted return.  Most Traditional  Portfolio Optimization tools use historical returns as an indicator of future returns.  Others use more realistic return  estimators that are defined by the user, but still do not incorporate scenario analyses like Alpha Theory.   In addition, we have proven through Monte Carlo simulation that Alpha Theory is the superior method for maximizing  portfolio expected return.  Markowitz mean‐variance does not beat equal weighting as a position sizing method and  Alpha Theory beats equal weighting by almost 80%. 

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    Alpha Theory Differentiation From Portfolio Op Tim Ization

    Uploaded by

    microsoftjohn1234
    Fundamental versus Traditional Portfolio Optimization  Alpha Theory enforces a discipline upon a firm’s decision process (position selection, sizing, and trading) by creating an  investment process based on risk‐adjusted return.  Alpha Theory then scales position sizes depending on the magnitude  of the risk‐adjusted return (ie. higher risk‐adjusted return equals a larger position size) to maximize the risk‐adjusted  return of the portfolio.  Portfolio Optimization (Risk Management) Tools use Modern Portfolio Theory, specifically Markowitz mean‐variance, to  ensure that the portfolio resides on the Efficient Frontier.  Additional measures like Value at Risk (VAR) and proprietary  statistics tools are folded into the optimization equation to maximize the return of the portfolio.  Traditional Portfolio Optimization is well suited for quantitative managers but not designed for the deep research of  fundamental asset managers.  The primary difference is how each measures return and risk.    Return.  Alpha Theory measures return by taking the analyst’s calculation of risk‐adjusted return.  Most Traditional  Portfolio Optimization tools use historical returns as an indicator of future returns.  Others use more realistic return  estimators that are defined by the user, but still do not incorporate scenario analyses like Alpha Theory.   In addition, we have proven through Monte Carlo simulation that Alpha Theory is the superior method for maximizing  portfolio expected return.  Markowitz mean‐variance does not beat equal weighting as a position sizing method and  Alpha Theory beats equal weighting by almost 80%. 

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    ModernPortfolioTheoryComparison

    FundamentalversusTraditionalPortfolioOptimization

    AlphaTheoryenforcesadisciplineuponafirmsdecisionprocess(positionselection,sizing,andtrading)bycreatingan investmentprocessbasedonriskadjustedreturn.AlphaTheorythenscalespositionsizesdependingonthemagnitude oftheriskadjustedreturn(ie.higherriskadjustedreturnequalsalargerpositionsize)tomaximizetheriskadjusted returnoftheportfolio. PortfolioOptimization(RiskManagement)ToolsuseModernPortfolioTheory,specificallyMarkowitzmeanvariance,to ensurethattheportfolioresidesontheEfficientFrontier.AdditionalmeasureslikeValueatRisk(VAR)andproprietary statisticstoolsarefoldedintotheoptimizationequationtomaximizethereturnoftheportfolio. TraditionalPortfolioOptimizationiswellsuitedforquantitativemanagersbutnotdesignedforthedeepresearchof fundamentalassetmanagers.Theprimarydifferenceishoweachmeasuresreturnandrisk. Return.AlphaTheorymeasuresreturnbytakingtheanalystscalculationofriskadjustedreturn.MostTraditional PortfolioOptimizationtoolsusehistoricalreturnsasanindicatoroffuturereturns.Othersusemorerealisticreturn estimatorsthataredefinedbytheuser,butstilldonotincorporatescenarioanalyseslikeAlphaTheory. Inaddition,wehaveproventhroughMonteCarlosimulationthatAlphaTheoryisthesuperiormethodformaximizing portfolioexpectedreturn.Markowitzmeanvariancedoesnotbeatequalweightingasapositionsizingmethodand AlphaTheorybeatsequalweightingbyalmost80%.
    Optimal Probabilityof Average ExpectedReturn Portfoliooutof beingOptimal Average Portfolio per1%of 10,000iterations Method Exposure ExpectedReturn Exposure AlphaTheory 8461 85% 141% 144% 104bps KellyCriterion 942 9% 139% 105% 75bps Up/DownRatio 559 6% 216% 155% 71bps EqualWeighting 38 0% 169% 100% 59bps MarkowitzMeanVariance(ModernPortfolioTheory)* *Twostudies(DeMigueletal(2006)/JobsonKorkie):14mostcommonmeanvariancetechniquesnobetterthanEqualWeighting Improvement using AlphaTheory 39% 45% 76% atleast76%

    Risk.ThemoreimportantelementdifferentiatingAlphaTheoryandothertoolsisthemeasureofrisk.Thisisillustrated byasimplequestion,Whatisabettermeasureofrisk?Howmuchsomethingmoves(variance)orhowmuchyoucan lose(potentialdownside)?MostwouldsayhowmuchyoucanloseandwouldpositthatVaRisameasureofhow muchaportfoliocanlose.However,VaRisstillmeasuringriskbasedonvarianceandcorrelation,notontheanalysts estimationofdownside.Todrivethepointhome,letscomparehowAlphaTheoryandTraditionalPortfolio Optimizationtoolsaddressriskofahypotheticalasset: CompanyXYZistradingat$25andhasastandarddeviationof40%,highbystatisticalmeasures,buthas$24pershare incashtoprotectthebuyeronthedownside.TraditionalPortfolioOptimizationwouldrequireasubstantialreturnto getoverthe40%standarddeviationhurdlerate,butinactuality,thedownsideislimited.Thisdownsidescenarioof$24 isfactoredintothescenariobasedriskadjustedreturncalculatedbytheanalystandiftheupsidemeritsacompelling riskadjustedreturnthenthispositionwouldsubsequentlybemadealargerpositionintheportfolio. Otherdifferentiations.ModernPortfolioTheoryandmostTraditionalPortfolioOptimizationtoolsassumealognormal distributionofmarketreturnstoperformtheircalculations.However,themarketisnotlognormallydistributed(there areamyriadofsourcesthatexpounduponthisidea,butTailTalesCFAMagazineMarch2007hasaveryconcise 1|P a g e

    ModernPortfolioTheoryComparison
    explanation).Theassumptionofalognormaldistributionofmarketreturnslimitstheeffectivenessofthevariance, correlationandBetasusedintraditionalportfoliooptimizations.Itdoesntmeanthattheyareineffective,justnot superlativeprognosticators. Additionally,twostudies,DeMiguel(2006)andtheJabsonKorkiefindingsbothstatethatofthe14mostcommonmean varianceoptimizationalternatives,nonebeatequalweighting.Theseconclusionsmakeittoughforafundamental investortoplacebetsusingTraditionalPortfolioOptimizationsystems. EventhoughtherearesomeissueswiththestatisticalassumptionsofTraditionalPortfolioOptimization,correlationand concentrationarestillpracticalconcernsthatmustbeaddressed.AlphaTheorytakestheapproachthatTraditional PortfolioOptimizationareveryimportantasawaytoprotecttheportfoliofromextremes(theBlackSwanmultiple sigmaeventformoreinformationreadFooledbyRandomness,Taleb). AlphaTheoryisnotdesignedtoreplaceTraditionalPortfolioOptimization.FundamentalandTraditionalPortfolio Optimizationbothhaveaplaceinfundamentalportfoliomanagement.Imaginethefundisasportscar.Theengineof thesportscaristheresearchoffirm.AlphaTheoryistheturbochargerthatmakessurethateveryounceofpoweris beingtranslatedintoperformance.TraditionalPortfolioOptimizationbecomestheairbagsandantilockbrakesofthe portfoliomanagementcar.Theypreventyoufromdyinginacrash,buttheydonotmakethecargofaster. AlphaTheorysgoalistomaximizepotentialriskadjustedreturnbutalsoincludessomeadditionalriskcontrolsdesigned forfundamentalportfoliomanagers. MarketExposure.AlphatheoryallowstheportfoliomanagertoBetaadjustpositionsizestocontroloverallmarket exposure.ThisisnotanindicationofAlphaTheorysbeliefthattheBetawillholdtrueinthefuture,butisour understandingthattherearefewbettertoolsforappreciatingmarketexposureofanindividualasset. IndustryExposure.AlphaTheoryalsoallowstheportfoliomanagertosetmaximumexposurestoindustries/sectors. Industryexposureisatrueriskandcapturesindustrybasedcorrelation.Thisisdifferentthanhistoricalstatistical correlationsthatmaynotpersistinthefuture. Liquidity.TheAlphaTheoryalgorithmincludesparametersthatallowtheportfoliomanagertodefineliquidity constraints,sothatexposuretoassetswithlowliquidityisreduced.Theportfoliomanagercansetminimumliquidity, definedbydollarvolume,andpreferredlevelsofliquidity.Ifanassetsliquidityfallsbelowtheminimumthenthe optimalpositionisautomatically0%,iftheliquidityisgreaterthanthepreferredlevel,thennoliquidityadjustmentsare made.Iftheliquidityfallsinbetweentheminimumandpreferred,AlphaTheorywilladjustthepositionsizeaccordingly tominimizetheexposureasliquidityapproachesminimumlevels.

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