Journal of Investment Strategies

Welcome to the first issue of the fifth volume of The Journal of Investment Strategies. In this issue, we present you with three papers: one on robust investment strategy design, one on performance evaluation of high frequency strategies, and one on assessment of structural alphas in the small cap market.

In the first paper in the issue, G. Charles-Cadogan investigates in detail the performance of high frequency traders and algo strategies, which in some cases report stratospheric Sharpe ratios on an annualized basis, sometimes as high as 10, or even higher. Such a big difference between the performance of high-frequency trading (HFT) and non-HFT investment managers has puzzled many industry experts, but it is usually just attributed to a claim that HFT strategies are often performing a quasi-market-making service and therefore their compensation must be more akin to an almost sure fee than to uncertain risky return. The author, however, diagnoses the problem differently - as a misspecification of the annualized Sharpe ratio metric in the case of the HFT strategy - and introduces an "effective Sharpe ratio" that corrects this misspecification. The resulting corrected Sharpe ratio numbers are a lot closer to those of other investment strategies, and one is led to think that, if measured on an apples-to-apples basis, there is a broad correspondence between all these different pockets of the investment management industry.

I am very intrigued by this novel interpretation and believe that the author may just have found the answer to the question that many hedge fund managers have asked themselves: "Should I also be doing high frequency trading, if it is so much more profitable than what I do currently?" I have asked myself this question as well, but my answer was based on a slightly different logic.

While I contend that HFT strategies are often far more profitable than "normal" ones, I think that the competitive landscape in the HFTworld is dramatically different. Unlike in conventional investment management, the total amount of profit is limited by the overall volumes traded in the market, and this creates a "winner-takes-all" (or the top few winners take all) structure for participants in HFT. Of course, at any given point in time the winners do get exceptional returns. But since it is difficult to maintain the competitive edge so that one is always not just better than average but is actually in the top few winning spots, then the true nature of the business returns will be intermittent, and the profits will immediately vanish (or even become losses) as soon as someone else edges just past you to be above the cutoff of the winners' circle.

For me, then, betting on an HFT strategy is akin to betting on a poker player to win a World Series title. Sure, if the player in question is a top pro, perhaps it is not such a bad bet, but if only the winner takes home the prize and the rest do not get paid anything, then even for such top players professional poker becomes a rather difficult profession. And for the rest of us, it is not even worth trying.

Charles-Cadogan's findings therefore make a lot of sense to me, as they mean that, after adjusting for the difficulty of being among the top winners, the average results of HFT traders would be in line with what other professional investors can achieve. This would mean that the trading ecosystem might actually be sustainable, and the often-heard fears that HFT will somehow displace traditional traders and investors are exaggerated.

In the issue's second paper, K. Smimou presents an extensive study of the dependence of the performance of the major equity sectors on energy markets. By setting the problem in a practical manner, as a task of finding an optimal addition of energy futures contracts to sector exposures in order to improve a sector rotation strategy, the author is able not only to demonstrate the importance of the energy exposure overall but also to calculate the differential impact of its inclusion on various sectors.

The question of macroeconomic dependencies in equity sectors is not a newone, but most of the studies that I know focus on bottom-up computations, which are difficult to carry through even though they might be important for the understanding of the overall picture. For me, empirical/phenomenological studies like this one carry a lot of weight because they allow us to let the data tell us the true story, and then see if that story is actually consistent with our intuition or if it requires changing our point of view. And the major added benefit of such a line of attack is that the result is not only illuminating but is actually directly applicable, ie, one gets a recipe for improving a long-standing trading strategy such as sector rotation in a nontrivial manner. To my mind, this makes Smimou's paper an ideal example of what we always strive to present in The Journal of Investment Strategies: an academically rigorous study and a methodology that has practical novelty and significance. I hope many readers will agree with me.

In our third paper, Elena Ranguelova, Jonathan Feeney and Yi Lu investigate the attractiveness of small cap equity strategies from an investor's perspective. They find that as an asset (sub)class, small caps offer unique features that make them more fertile ground than large caps for finding truly alpha generating investment managers. They demonstrate that there are structural reasons for this, including insufficient coverage by research, lack of focus by large investors, liquidity premium, etc.All of this makes a lot of sense, and I agree completely that, as long as those structural differences persist, the small cap sector is likely to continue to offer alpha generating opportunities for managers and their investors.

I would like to thank our readers for their continued support and interest. I hope that they will find something useful in this issue of The Journal of Investment Strategies and that we will be able to continue to offer equally interesting issues in the future.

Arthur M. Berd
General Quantitative LLC