Calculating how much you need to launch Your Own Hedge Fund (Part 6)

2014-10-11

This was meant to be the last posting in this series, but as I was drafting this entry, I realised that there may be some who wish to know if the methods I outline, and the strategies I trade, are suitable for a larger amounts of capital than I have discussed.  Therefore, following this post I will add one more, presenting the results for portfolios of $1 million, $5 million, and $10 million (where $ equals USD, AUD or CAD!). 

In Part 5 (http://yohf.net/2010/11/28/calculating-how-much-you-need-to-launch-your-own-hedge-fund-part-5/) I presented a portfolio of 7 trading strategies, and showed how someone with just over $70,000 could generate returns of 29.71%, with a volatility of 12.36%, and a maximum drawdown of $15,160 (all based on historic data, so you would need to take a more conservative view of these numbers for future forecasts). 

Today I will present the final part of my originally planned series, and show how, with more trading strategies and more money, the home based hedge fund manager can further improve their return / risk profile, and improve their POTS score (introduced in Part 4 of this series: http://yohf.net/2010/11/15/calculating-how-much-you-need-to-launch-your-own-hedge-fund-part-4/). 

Obviously, as you add more strategies, the opportunities for improvement with your overall portfolio diminish, as the opportunities to find uncorrelated strategies diminish (the more strategies you run, the increased probability that two will have similar or correlated results).  We are going to stop with 10 strategies.  I Part 5 of this series I outlined the first 7, but I will not share the details on these 3 additional strategies.  Suffice to say, the highest correlation between any two of the 10 strategies over the past 3 years is 63%, and about 30% of entries in my correlation matrix are negative. 

Increasing the number of strategies from 7 to 10 requires an increase in Starting Capital from $71,507 to $210,975.  As mentioned last time, as we get more capital under management, our (OK, my!) discomfort with a loss becomes more severe.  Therefore, while I could live with a 21.20% drawdown with a $71,507 account (or $15,160 maximum drawdown), I would be far less comfortable with a similar percentage drawdown from a capital base o $200,000+.  

However, this increase also allows you to greatly increase your Raw POTS Score, by reducing both your volatility and max drawdown percent, without negatively impacting your returns. 

Results from a portfolio of 10 Trading Strategies: 

  • Starting Capital    $210.975
  • Annual Return    30.61%
  • Annual Volatility    10.68%
  • Information Ratio    2.30
  • Max Drawdown     $38,450
  • Max Drawdown %     18.22%
  • Raw POTS Score 12.64

Conservative Results from a Portfolio of 7 Trading Strategies:

  • Starting Capital   $210,975
  • Annual Return     20.41%
  • Annual Volatility   13.08%
  • Information Ratio    1.10 
  • Max Drawdown    $57,675
  • Max Drawdown %    27.34%
  • Raw POTS Score    4.03

As usual, I produce a Probability Distribution based on the above Conservative Return and Risk (Volatility) data, and then run a Scenario Analysis to determine the results that could be derived from these figures. So it all looks pretty good. (just click on the images to expand them to a legible size) 

Scenario Analysis - 10 Model Portfolio (conservative results)

 

Probability of Returns - 10 model historic returns (Conservative)

So, in summary, the more money you have to launch your hedge fund, the better you can engineer your return and risk profile.  But for those who don’t have $200,000, don’t despair.  An obvious strategy is to start with a smaller amount (let’s say $24,000) and fewer (but at least 3) trading strategies, and then add non-correlated strategies to your portfolio as your fund grows.  Easy!

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