Author: AliCatCapital , Last Modified, 2022-03-09

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How to Measure Alpha when Allocating Capital to a Basket of Stocks in a Risk Based Position Trading Portfolio for Hedge Funds

How to measure Alpha when allocating capital to a basket of stocks in a position based trading portfolio.

The comparison of any two stocks is typically a difficult thing to do using absolute share prices. It is helpful for the hedge fund manager to re base historical share prices and compare relative price movements. There are a few ways to do this and this is the way I used to do it when operating my hedge fund, AliCat Capital Management, see the chart image above.

The model proves what the academics tell us is so in practice. The chart is a snapshot of a bullish market, where all stocks observed are clearly exhibiting high returns. These returns are not smooth however and this is where the short term trader of the trader using tight absolute stop losses will loose out. The higher returning stocks are clearly more volatile than low return stocks. In the longer run the best returns are only possible by taking risk. Of course you will want to take measured risk.

This is achieved by diversifying the portfolio and allocating capital using the Alpha model as described in the other article on measuring Aplha.

The volatility is a tool for calculating STOP LOSSES. Most articles I read describe using absolute stop losses. Either suggesting a fixed percentage i.e. 5% price movement or x amount etc.. This is of course nonsense. It makes little sense to me. High beta stocks will invariably be "Shaken Out" by your sell triggers well before they ever yield a return in your account. I therefore recommend utilising algorithmically defined stop losses. My Models use a multiple of the Standard Deviation of Returns and the Multiple, which is really the secret sauce so to speak, is essentially worked out over time, through trial and error, or what you might call iteratively. Doing so by applying a experience and judgement of course.

The extent to which you want to use larger multiples of standard deviation in stop loss or take profit triggers, will to a large extent depend on the overall market cycle.

The Red Lines are a measure of Return the Blue are a measure of Risk or Volatility.

The slope of the red line and the strength of the volatility are used to compute the risk return ratios which help us to determine capital allocation.

Note the measures are modified for the basket of stocks and so differ from the individual measure we observe in any given stock.

This exercise is not performed on a stock by stock basis of course, rather it is performed on the entire market at once. This results in an efficient data set which is filtered for stocks that meet the hedge fund managers criterion for stock selection.

Stock picking can then be based on a measured set of data points reflecting the aggressiveness or otherwise of the money manager.

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