The Strategy Approval Decision: A Sharpe Ratio Indifference Curve Approach

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

David H. Bailey

Lawrence Berkeley National Laboratory; University of California, Davis

Marcos Lopez de Prado

Guggenheim Partners, LLC; Lawrence Berkeley National Laboratory; Harvard University - RCC

Eva del Pozo

Universidad Complutense de Madrid (UCM)

Date Written: January 1, 2013

Abstract

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 Lopez 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: https://ssrn.com/abstract=2003638 or http://dx.doi.org/10.2139/ssrn.2003638

David H. Bailey

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.davidhbailey.com

University of California, Davis ( email )

One Shields Avenue
Davis, CA 95616
United States

HOME PAGE: http://www.davidhbailey.com

Marcos Lopez de Prado (Contact Author)

Guggenheim Partners, LLC ( email )

330 Madison Avenue
New York, NY 10017
United States

HOME PAGE: http://www.QuantResearch.org

Lawrence Berkeley National Laboratory ( email )

1 Cyclotron Road
Berkeley, CA 94720
United States

HOME PAGE: http://www.lbl.gov

Harvard University - RCC ( email )

26 Trowbridge Street
Cambridge, MA 02138
United States

HOME PAGE: http://www.rcc.harvard.edu

Eva Del Pozo

Universidad Complutense de Madrid (UCM) ( email )

Carretera de Humera s/n
Madrid, Madrid 28223
Spain

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