How can we help?
< All Topics

Introduction to trading

Active Portfolio management is the science of structuring a portfolio of investments to protect the capital of clients (investors) and generate steady returns in both rising and falling markets.

The performance of a portfolio management strategy is measured by its Sharpe ratio which summarises in one number the investment return generated compared to the risk undertaken.

Successful portfolio managers generate sharpe ratios between 1.0 and 3.0 in all market environments including economic recessions and bear markets.

The aim of portfolio managers is to generate consistent adjusted returns with high sharpe ratios, compounded over many years to generate growth and wealth creation.

Ray Dalio Investment Principles

One of the most successful investors is Ray Dalio, founder of the world’s largest hedge fund ($150bln AUM). The most important principles in investing are:

  • The holy grail of investing is finding 15 or more good uncorrelated return streams
  • Diversification can reduce risk more than it reduces returns so it improves return-to risk ratio
  • Return streams can be risk adjusted to be risk balanced
  • Systematic decision making; rules should be timeless and universal

MacroVar was designed to provide you with the models and portfolio management tools to manage your portfolio with these principles in mind. Sign Up free.

Evaluating Portfolio Management Strategies

To examine a portfolio management strategy, you need to analyse the following metrics for a historical period including bear markets, bull markets and different economic environments:

  • Average Annual returns: Average annual return (AAR) is the percentage historical return of an investment portfolio.
  • Volatility: Volatility describes the degree to which an investment portfolio’s value moves up and down. This is the portfolio’s risk. If an investment portfolio has an average annual return of 10% with a volatility of 15%, investors should expect annual returns to fall within a range of 5% (10% minus 15%) to 25% (10% plus 15%).
  • Sharpe Ratio: Sharpe ratio helps investor understand the return of an investment portfolio compared to its risk. Successful portfolio management strategies generate the highest return possible with the lowest volatility. Successful portfolio managers generate sharpe ratios between 1.0 and 3.0.
  • Maximum Drawdown: An portfolio management strategy suffers a drawdown when it loses money. Maximum drawdown measures the largest single drop from peak to bottom in the portfolio’s value. Investors in a fund with a max drawdown of 50% saw their portfolios lose half of their value. Investors should select portfolio managers which have historically generate good returns with the lowest possible maximum drawdown. Portfolios with Maximum Drawdown between 5% and 20% are considered professionally managed portfolios.
  • Performance Consistency: A portfolio manager’s performance should be examined for long historical periods of at least 10 years to confirm how an portfolio performed during different market environments (Growth, Recession, bull and bear markets).

Market crashes:Special attention must be given on how an investment portfolio performed during market crisis like 2000 dot-com bubble, 2008-2009 crash etc.

Longer periods of historical performance often guarantee similar future portfolio performance irrespective of the market environment.

Comparing Portfolio Management strategies

Before selecting a portfolio manager, you should compare his portfolio’s historical performance with benchmarks like the US stock market index (S&P 500). However, the correct metric to compare the performance of a portfolio manager with a benchmark is not the annual return generated but the sharpe ratio generated. You need to compare the return generated per unit of the volatility experienced. To make thigs clearer check below the comparison of 2 investment portfolios.

Assume you had to choose between two portfolio managers with the portfolio’s performances displayed above. Although portfolio manager two has a higher ending value than portfolio manager one, his portfolio experienced a much higher volatility and drawdown than portfolio manager one. Most probably, portfolio manager one structure a more diversified, balanced investment portfolio which was able to generate smoother returns with lower volatility. The investment portfolio of the manager one outperformed the portfolio of portfolio manager two generating a sharpe ratio three times higher.

In the example above, during the second half of 2013, the second portfolio value dropped from $160,000 to $105,000 losing 35% of its value. On the other hand, the first portfolio experienced during the same period a maximum drawdown of just 4.5%.

Active Portfolio Management

A portfolio manager also known as a professional trader is a full-time trader working at an Investment Bank or Hedge fund.

The aim of portfolio managers managing a typical portfolio involves structuring a long / short diversified portfolio of 10 to 20 uncorrelated investment positions.

Professional active portfolio managers in hedge funds, investment banks and other investment firms follow a specific approach to manage their portfolios.

MacroVar Framework

The MacroVar framework aims to utilise the best of what works from Macroeconomics. Microeconomics, fundamental analysis, quantitative models and risk management to stack the odds as high as possible to generate consistent returns with low risk in all risk environments.

The MacroVar framework consists of the following stages:

  1. Global Macroeconomic Conditions: Macroeconomic conditions are monitored daily by analysing leading macroeconomic indicator releases to predict global economic growth 6-12 months ahead.
  2. Country Macroeconomic & Geopolitical conditions: Macroeconomic conditions and newsflow for a specific country are monitored to predict economic and inflation expectations which affect the country’s stock market, bonds and currencies.
  3. Sector/Industry Analysis: Financial reports and research are used in a bottom up approach to identify potential investing opportunities across all sectors and industries globally.
  4. Financial Markets Overview: MacroVar Quantitative Models and Factor Models are used to monitor financial assets price dynamics and the macroeconomic and financial factors affecting them. The Financial markets monitored are:
    1. Stocks
    2. Short-term interest rates (STIR)
    3. Bonds
    4. Credit
    5. Forex
    6. Commodities
  5. Risk Management: Current Global financial risk and volatility models are used to in combination with asset’s volatility & rolling correlation parameters to adjust the portfolio’s overall net exposure and individual positions.
  6. Portfolio Management: Based on real-time analysis of Global Macroeconomic, geopolitical newsflow, quantitative models, factor models and risk managmeent models, the portfolio’s structure is continuously monitored and updated on the following levels: gross exposure, net exposure, beta hedging, position sizing.

Let’s get started with the top down approach.

If however you are interested in passive portfolio management strategies generating consistent returns with low risk and minimal effort click our asset allocation guide or our free database of investment strategies.

Table of Contents