Journal of Investment Strategies

Welcome to the latest issue of The Journal of Investment Strategies. In this final issue of the fourth volume, we are happy to present you with four papers covering a diverse set of topics, from portfolio construction to market microstructure to optimal game strategies to analyzing a market crash.

In the first paper of the issue, Emmanuel Jurczenko, Thierry Michel and Jérôme Teiletche put forward a unified framework for risk-based investing: a rather broad segment of portfolio management techniques that encompass well-known examples such as equal weight, minimum variance, maximum diversification and risk parity. The authors demonstrate how all of these special cases can be derived from a generalized risk-dependent portfolio optimization setting, with two parameters (risk sensitivity and weight sensitivity) determining which special case is obtained. Risk-driven strategies have gradually gained broad acceptance, and there now exist
various investment vehicles - from hedge funds and mutual funds to structured products and investable indexes - that implement these approaches. While many of them appear to outperform conventional market-cap-based passive portfolios, there are important commonalities as well as differences between these approaches and the paper strives to clarify them and to analyze the resulting portfolios within more conventional market and style factor approaches. I believe that this analysis, in particular, will be especially relevant to practitioners who wish to understand the impact of the changes in market conditions on the performance of these strategies and, conversely, the potential impact of the rebalancing of these strategies on the broader market.

In our second paper, Nataliya Bershova, Christopher R. Stephens and Henri Waelbroeck discuss the market impact of visible and dark orders. This paper explores an important new dimension in the rapidly growing market impact literature by distinguishing between the impact of market and limit orders executed against both displayed and dark order books. They find important differences between the size of the impact across the types of venues, and they are able to define a more precise market imbalance metric based on this while at the same time reconfirming the concave nature of the market impact function. Given the importance of different execution venues (encompassing both traditional exchanges and dark pools) and the growing practice of smart routing of large orders across many such venues, we believe that this paper's findings will be relevant for many practitioners designing optimal execution processes.

In the issue's third paper, Ralph Vince and Qiji Zhu revisit the classic Kelly-Thorp optimal betting problem and modify its setting in two important practical ways: by limiting the total number of games to be finite and by replacing the "optimal growth" objective by a maximum risk-adjusted return objective. The resulting modified Kelly criterion exhibits a more conservative optimal bet size and more nuanced dependence on the parameters of the game. Both of these modifications make the problem more similar to the traditional portfolio management setting, while the betting strategy still provides a useful toy model in which the information-theoretic approach can be used effectively.

Finally, in our forum section, we are happy to present a highly topical paper from the team of Didier Sornette, Guilherme Demos, Qun Zhang, Peter Cauwels, Vladimir Filimonov and Qunzhi Zhang: "Real-time prediction and post-mortem analysis of the Shanghai 2015 stock market bubble and crash". In the last few months we have witnessed a developing and accelerating market crash in Chinese domestic shares, and more recently its consequences have started to spill over into developed markets as well.Very recently it was the catalyst of the largest one-day gap open in US equity markets since the end of the financial crisis, spooking many investors, both professional and nonprofessional. Sornette and his team demonstrate how their Financial Crisis Observatory metrics correctly flagged the growing risks of a sharp correction in the Shanghai stock market index, initially in early 2015 and then repeatedly in April-June 2015. The magnitude of the correction in this index since then warrants describing this as a veritable crash, not unlike the one that occurred in Chinese markets in 2007 or the Nasdaq one that occurred in 2000-2001. This paper not only attracts attention to the topic of bubble diagnostics and crash prediction, but also provides computational methodology and a comprehensive set of references, giving interested readers a clear illustration of the authors' log-periodic power-law singularity model and a direct path to learning about it.

I would like to thank our readers for their continued support and interest, and hope that they will find something useful in this issue of the journal, just as they have in the ones before and the ones that will come after.

I would also like to make you aware that we have sent out a survey asking for your feedback on Risk Journals. You can access the survey at: www.risk.net/journal/feedback. Your participation is appreciated.

Arthur M. Berd
General Quantitative LLC