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OUR TAKE
Allocation models that know their
unknowns
Quants say probabilistic programming beats machine learning in
balancing strategies

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Faye Kilburn Quant firms are buzzing with ideas about algorithms that can ‘learn’ how best to adjust the
@Fayekilburn mix of assets and strategies they trade. But another technology – probabilistic programming – Asia moves: HSBC
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The approach allows firms in their portfolio allocation to build models incorporating the kind of transaction banking head,
market savvy that traders take for granted and also to construct a probabilistic view of future and more
returns, according to Thomas Wiecki, head of research at hedge fund Quantopian. Both are
FOLLOW i Bonds fall from favour as
areas where voguish machine learning models now now
now being
being
being employed
employed
employed in allocation can
shock absorbers for
struggle.
Faye Kilburn equity losses
Portfolio allocation decisions hinge on how markets are primed SOFR trading surged at
Asset management
to move and how linkages between strategies or assets are year end
View more + likely to evolve. Allocation calls often shape fund performance
more than security-level choices, particularly for a fund such
as Quantopian that crowdsources strategies, including from
amateur quants.

Quant funds see the area as ripe for the application of new
technology because the linkages in question often are
complex and non-linear. Thomas Wiecki

Firms have built machine learning allocation models that learn from historical data how assets
and strategies might behave in different marketsnow
andbeing employed between them could
how relationships
change. These models start, though, with no base understanding of how markets work and
can latch onto spurious patterns in the data, ascribing them unfounded meaning.

Models that use probabilistic programming, by contrast, start out with rules about how
markets function but include an element of uncertainty about how far those rules will hold.
The models simulate millions of future paths for a given portfolio within those boundaries.

“Compared to machine learning, probabilistic programming allows you to build a model that is
far more targeted and incorporates much more information about the domain of the problem,”
says Wiecki. “We might know that the correlations often have a certain structure or that
volatility tends to change over time,” he says. “If we can prime the model to say ‘this is the
direction to look in’, that is really helpful.”

Probabilistic programming essentially automates Bayesian inference, the statistical technique

whereby the probability of a given event is updated step-by-step based on fresh evidence.
Only recently have these tools become powerful enough to use in models at the scale
needed for quant finance.

Quantopian’s models generate a probability distribution of future daily returns for the dozens
of different strategies the hedge fund runs, based on past performance data. “Sometimes,
due to luck, even a bad strategy will have a good run and a good strategy will have a bad run.
Those would be scenarios we consider in the millions of forecasts that we simulate,” Wiecki
says.

The approach allows the firm to find the portfolio balance that works best across all possible
future scenarios, rather than just the most likely scenario and lets the firm be more
“principled” about the uncertainty in its forecasts.

“A strategy that has a good track record could be good, or it could have got lucky, or it could
be overfitted. We can never truly know which,” Wiecki says.

Topics Asset allocation Asset management Machine learning Our take Quant investing

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