Trading Portfolio Risk Analyzer

The Trading Portfolio Risk Analyzer is based on the application of game theory concepts to the analysis of the performance of trading portfolios. The central concept in the Analyzer is to view the portfolio's performance as the result of a "game" played between the advisor and its "opponent," the markets. In order to characterize the quality of the portfolio manager's strategy, the portfolio's trades are analyzed by viewing market action as a generalized random walk in the presence of an unknown amount of non-random movements. The higher the efficiency of capture of this non-random behavior by the trading portfolio, the higher the performance reading obtained by the Analyzer. Conversely, when the portfolio's activity is "out of sync" with the markets, the obtained readings will be low, or even negative.

Input to the Trading Portfolio Risk Analyzer

The input to the Trading Portfolio Risk Analyzer is very simple: A running report of the trades in the portfolio, both open and closed.

It must be emphasized that the Analyzer does not require any information whatsoever about the specific markets or instruments the portfolio is invested in, nor does it need to know the buy and sell signals that were used. All that is required is a running report of the profit or loss generated by each open and closed trade. Thus, the data provided to the Analyzer does not disclose any proprietary information.

Output of the Trading Portfolio Risk Analyzer

The Analyzer produces a report on the current performance of the portfolio, including an estimate of the likelihood that the methodology is about to deliver a performance outside of acceptable statistical ranges. Note that this "acceptable range" -which is determined on the basis of completely general game theory concepts- is independent of the portfolio history; that is, it is not necessary to compare current trading results with historical performance.

One of the most important measurements obtained by the Trading Portfolio Risk Analyzer is the "M-indicator." Middle-range values of M indicate a "comfortably good" portfolio performance ("the green zone.") High values of M generally indicate unsustainably good manager performance. Low values indicate possible problems ("the yellow zone,") while very low or negative values of M indicate serious difficulties in the portfolio's performance ("the red zone.")

An Example: Advisor Switching Strategy Using the Analyzer

As an example of the application of the Analyzer, consider a fund manager using several advisors. It is assumed the manager has one favorite advisor managing most of the assets, while, in general, the remaining advisors are primarily viewed as a "back-up" to the main advisor. The fund manager would like to use a technique that would indicate when to switch between the main advisor and one of the back-ups.

The figure above shows the results of the Analyzer's evaluation of the performance of the main advisor taken alone. The graph shows the value of the M-indicator for each day. We clearly see in the picture that, over time, the performance of the advisor is deteriorating: as times goes by, more and more time is spent in the yellow and red zones. In particular, serious problems are occurring in the periods (day numbers) 1150 to 1200, and 1275 to 1330.

The figure above shows a comparison between the main advisor's individual equity line (cumulative profit/loss results) and the e-line resulting from a switching strategy using the Analyzer. The figure shows that, indeed, the main advisor's portfolio e-line (purple line, labeled "Main Advisor") suffered two significant drawdowns during the periods mentioned, and that it would be desirable to switch assets from the main advisor during these periods.

To handle this situation, the Analyzer was used to generate timing signals to switch assets from the main advisor to one of the back-up advisors. The switch was executed each time the main advisor's M-indicator signaled problems with the main advisor's methodology. The back-up advisor receiving the assets was also selected on the basis of their M-indicator status at the time. Assets are switched back to the main advisor as soon as its M-indicator shows the main advisor's performance is returning to an acceptable level. If neither the main nor the back-up advisors are in the acceptable range, the fund's assets are assumed to have essentially gone to cash.

The result of such a strategy is shown by the red and blue line (labeled "Switched e-line,") which shows a markedly improved performance. In particular, the substantial drawdowns suffered by the main advisor have been significantly reduced.

The red portions in the switched e-line indicate time periods in which the main advisor has been "switched out," while the blue portions indicate periods in which the main advisor is "in", i.e. is managing most of the fund's assets.

As an interesting aside, it should be noted that the period 1275-1330 wasn't just a problem for the main advisor, but rather a more difficult market period in general: none of the back-up advisors have been able to generate returns either, and the switched portfolio equity line has gone flat.

The above example illustrates clearly that the Analyzer can give "advance warning" of serious problems in portfolio performance, allowing action to be taken in a timely fashion. Therefore, the Analyzer can be a very beneficial addition to a fund manager's decision tool set.

The Trading Portfolio Risk Analyzer is available through ASP (Application Service Provider) arrangements with ZCM, as a custom software package, or for consulting or joint-venture projects.

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Last modified: Tuesday, Jun 8, 2004, 12:52:14