Connors Research Traders Journal (Volume 2): How To Increase The Sharpe Ratio of Your Portfolio
In this issue of The Connors Research Traders Journal (Volume 2), we’ll delve into the insights of Peter Muller, who built PDT (Process Driven Trading), one of the greatest proprietary trading firms in the world for Morgan Stanley. Peter and his team then moved from Morgan Stanley to their own $5+ billion quant hedge fund. Reportedly, Peter and his team have achieved returns (after fees) of over 20% annually since the early 1990’s. Even though he is highly secretive in discussing their trading (Peter and his team have written little and said even less on how they trade), this article, published in Quantitative Finance, is one of the few pieces out there, and it has a number of gems in it. These gems can give you a better insight into how to build portfolios with greater returns and with lower risk.
You can read this rare article by clicking here. After reading the article please read the analysis below (for a full understanding of the Sharpe Ratio, click here).
Highlights of Peter Muller’s Insights:
1. What are Good Sharpe Ratios? – Portfolios with Sharpe Ratios above 1.0 are considered very good (see Figure 2 in Muller’s article). Sharpe ratios above 2.0 are exceptional. If you’re trading live money over a sustained period of time (meaning years) with a Sharpe Ratio above 1.0, you likely have something that’s very solid.
2. Higher Portfolio Turnover Can Increase The Sharpe Ratio – Higher frequency trading can lead to higher Sharpe Ratios (for example, High Frequency Trading firms usually have very high Sharpe ratios – they also have their own unique set of problems).
I view this in two ways:
a) Increasing the frequency of high quality of trades can lead you to a higher Sharpe Ratio. Muller goes as far as to suggest this and we’ll examine this together in number 4 below.
b) If you have a “low frequency portfolio” (one that doesn’t turnover too often) that has a high Sharpe Ratio (above 1.0) you likely have something special.
3. Strategy Correlations Matter – Closely monitor the correlations of your strategies. In his opinion, multi-strategy portfolios often have strategies that are more correlated than the trader believes. If in fact your strategies are not highly correlated you again potentially have something special. Ray Dalio (whose best-selling book Principles is must reading) has stated on numerous occasions that having a number of uncorrelated strategies together in one portfolio is one of the greatest ways to build a superior portfolio.
4. It’s Better to Go Deeper than Broader – I found this one particularly interesting. In Muller’s opinion, if one had to choose between adding more strategies, or adding more trades to an already strong strategy, he feels the latter is better. Again his concern is that the additional strategies may be too correlated to the existing strategy and it’s likely easier to find more high quality trading opportunities with the existing strategy than to find a new high performing uncorrelated strategy.
In our own observations, we have seen improved Sharpe Ratios when we tested combining low-correlated strategies (as Dalio suggests). Until reading Peter Muller’s interview though, we’ve never considered looking for ways to add additional high-quality trades to strategies with high Sharpe Ratio’s. We’re looking forward to pursuing this further, especially because the idea came from Muller and it’s potentially highly scalable.
Summary:
Obviously when an individual who oversees one of the greatest proprietary trading firms in history provides insights, it’s worth a lot. The Sharpe Ratio is not the only metric available to measure the quality of a portfolio but it remains one of the most important.
– Things to avoid include correlated strategies.
– Things to pursue include finding more high-quality trades with existing high Sharpe Ratio Strategies.
– Measure your strategy correlations, especially during the periods of market stress; for example, 2008, August 2011, the fourth quarter of 2015, and February 2018. Did your strategies’ correlations rise during those periods? If they did not, that’s a good sign.
– I’ll add another piece of analysis you can look at to see how your portfolio did during times of stress. Look at the down months in SPXTR (the S&P 500 Total Return Index). Did your portfolio also lose money those months (and were the downside moves especially large)? If it did, you may want to include an additional uncorrelated strategy which tends to smooth returns during times of stress.
– The other area to pursue according to Peter Muller is to take a high Sharpe Ratio strategy and see if you can increase it’s trading frequency with additional high-quality trades. This may increase your Sharpe Ratio, and it may also increase your overall returns.
I hope you enjoyed this issue of the Connors Research Traders Journal. Enjoy your trading!
Larry Connors
Connors Research LLC
P.S. Are you looking for private one-on-one mentoring to further improve your trading? If you are call 888-484-8220 ext. 1 for additional details.