Quote:
Originally Posted by hedgefundguy
well thank you
Let me begin to explain the advantage of a multistrategy hedge fund. I will use a simple model (and try to build it out over time)
Let's say we can identify a trader who (through deep knowledge and research) is able to make 100 investment decisions a year with a 52/48 edge (right 52% of the time) with symmetric gains and losses.
If the trader bet $10 on each view, he/she would on average make $40 a year with a standard deviation of approx 50--a 0.8 information ratio.
If you can find 10 such traders (assuming uncorrelated), then you would expect to make $400 a year with a standard deviation of approx 160--a 2.5 information ratio.
**note: even if you scaled each trader's bets to 3 dollars, you would make $120 a year with the same SD of 50 as we had before**
So far, so good. This is basically the Millennium model.
More to come...
Continuing...altered the numbers above up by a factor of 10 for ease of calculations.
Now, let's assume that one of the 10 traders has an enhanced edge for a certain period of time (let's say this happens to all traders 10% of the time, so you expect 1 on average). That trader now has a 55 percent chance of winning per bet. (If this were blackjack, this trader has a big plus count...if poker, a "live player" or two has entered that trader's table)
This trader alone has a information ratio of near 2 (I will leave it to you to confirm). Moving 100% of the capital to this trader would be a worse risk/reward than before, but certainly it should be increased. Now you may want to let this trader bet $7 per hand during this period, and to keep standard deviation (risk) neutral, decrease the other traders bets to $2 per hand. Now your expected win is (10*7)+(4*2*9) = $142 for approx the same SD...information ratio up to 2.84
When the fund has only one trader, that trader had a 0.8 info ratio 90% of the time and a 2.0 10% of the time. Because that trader is the only strategy and investors don't want to pay fees to sit out, the firm is taking a similar amount of risk at all times and the info ratio is a little over 0.9 including these enhanced return periods.
Adding 9 equally talented traders takes the firm's info ratio from 0.9 to 2.8 from diversification (largely) and increased ability to alter bet sizing when you have an increased edge.