To The Moon

Idio

I just started reading Advanced Portfolio Management by Giuseppe Paleologo.

About the author

• He’s on garden leave after running risk at Hudson River Trading. He has also held senior positions at Millennium, Citadel, Axioma, and IBM Research. He was formerly a mathematical researcher at Stanford and an instructor in the master’s program in Financial Engineering at Cornell University.

I started reading this book because I was interested in how fundamental investors think about risk and performance attribution. I heard the book was standard issue at Citadel for pod PMs. I haven’t verified that but I did notice that Brett Caughran strongly recommended it in his terrific 5 THINGS I WISH I KNEW AS A FIRST TIME HEDGE FUND PORTFOLIO MANAGER thread.

The first 2 chapters are brief background info. Chapter 3 starts the journey. My notes (which are intended to be references for me as opposed to “study notes”):

Chapter 3: A tour of risk and performance

• Alpha is the expected value of the idiosyncratic return and epsilon is the noise masking it.
• There’s general agreement that accurately forecasting market returns is very difficult or at least not the mandate of a fundamental analyst. A macro investor may have an edge in forecasting the market, but the fundamental one does not have a differentiated view.
• The job of the fundamental investor is to estimate alpha accurately
• The risk manager’s job is to estimate beta and identify the correct benchmark
• The error around an alpha estimate is larger than that alpha estimate itself. This is not true for beta. You cannot observe alpha directly and you cannot estimate it from a time series of returns. The fundamental analyst predicts forward-looking alphas based on deep research. The ability to combine these alpha forecasts from a variety of sources and process a large number of unstructured data is a competitive advantage of the fundamental investor.
• The chapter decomposes alpha(idio) and beta contribution and risks

Kris: found this helpful for understanding portfolio alpha even though I’ve covered this all before in https://moontowermeta.com/from-capm-to-hedging/ from my own experience.

This is my take:

What the industry calls “idio”, I refer to as “risk remaining”. Same exact concept.

If X = market and Y = stock then this identity decomposes the risk:

Stock variance = Market variance + Idio variance

Var (Y) = R² * (VarY/VarX) + (1-R²) * (VarY/VarX)

Note that market variance is Beta² so:

Beta = R * (σᵧ /σₓ )

Risk remaining or idio is a non-linear function of correlation. As correlation drops, idio explodes. Once R is .86 or lower the idio risk exceeds the market risk!

Fyi, It’s a short book, 168 pages plus appendices.