The Strategy Approval Decision: A Sharpe Ratio Indifference Curve Approach

12 Pages Posted: 15 Feb 2012 Last revised: 20 Jan 2014

See all articles by David H. Bailey

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Marcos Lopez de Prado

Cornell University - Operations Research & Industrial Engineering; Abu Dhabi Investment Authority; True Positive Technologies

Eva del Pozo

Universidad Complutense de Madrid (UCM)

Date Written: January 1, 2013


The problem of capital allocation to a set of strategies could be partially avoided or at least greatly simplified with an appropriate strategy approval decision process. This paper proposes such a procedure.We begin by splitting the capital allocation problem into two sequential stages: strategy approval and portfolio optimization. Then we argue that the goal of the second stage is to beat a naïve benchmark, and the goal of the first stage is to identify which strategies improve the performance of such a naïve benchmark. We believe that this is a sensible approach, as it does not leave all the work to the optimizer, thus adding robustness to the final outcome.

We introduce the concept of the Sharpe ratio indifference curve, which represents the space of pairs (candidate strategy’s Sharpe ratio, candidate strategy’s correlation to the approved set) for which the Sharpe ratio of the expanded approved set remains constant. We show that selecting strategies (or portfolio managers) solely based on past Sharpe ratio will lead to suboptimal outcomes, particularly when we ignore the impact that these decisions will have on the average correlation of the portfolio. Our strategy approval theorem proves that, under certain circumstances, it is entirely possible for firms to improve their overall Sharpe ratio by hiring portfolio managers with negative expected performance. Finally, we show that these results have important practical business implications with respect to the way investment firms hire, layoff and structure payouts.

Keywords: Portfolio theory, Sharpe ratio, pairwise correlation, indifference curve, diversification

JEL Classification: C02, G11, G14, D53

Suggested Citation

Bailey, David H. and López de Prado, Marcos and López de Prado, Marcos and del Pozo, Eva, The Strategy Approval Decision: A Sharpe Ratio Indifference Curve Approach (January 1, 2013). Algorithmic Finance, (2013) 2:1, 99-109, Available at SSRN: or

David H. Bailey

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States


University of California, Davis ( email )

One Shields Avenue
Apt 153
Davis, CA 95616
United States


Marcos López de Prado (Contact Author)

Cornell University - Operations Research & Industrial Engineering ( email )

237 Rhodes Hall
Ithaca, NY 14853
United States


Abu Dhabi Investment Authority ( email )

211 Corniche Road
Abu Dhabi, Abu Dhabi PO Box3600
United Arab Emirates


True Positive Technologies ( email )

United States


Eva Del Pozo

Universidad Complutense de Madrid (UCM) ( email )

Carretera de Humera s/n
Madrid, Madrid 28223

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