Portfolio Management
Portfolio Construction
In our portfolio construction, we are driven by the notion that we can only set the level of portfolio risk, and the market will eventually dictate returns. We do not emphasize top-down (tactical) allocation based on relative return expectations across the various hedge fund strategies. Rather, we take a more bottom-up approach where risk parameters on the portfolio level determine the allocation across individual hedge funds. Allocation limits to certain strategies and managers are applied to control concentration risk. Our portfolio construction process entail the following five stages:
- Set portfolio’s target risk/return and investment guidelines:
- downside risk parameters
- market exposure limits
- concentration limits
- liquidity profile
- Bottom-up selection of funds based on unique attributes to the portfolio
- Establish target allocations per fund based on added value, investment and operational conviction scorecards
- Quarterly review of portfolio risk and diversification parameters
- Capital allocation in accordance with target allocation and risk profile
Risk management
At Theta Capital, risk management is an integral element of our manager selection and portfolio construction processes, rather than a separate task to be performed after the fact. The main question in portfolio construction is: how many independent bests with an attractive risk-return profile are available for investment? We manage diversification across single fund, manager, strategy, trading style, asset type, geography, market risk factors (equity, credit, volatility, etc), and non-market risk (counterparty, funding liquidity, operational, business).
Risk management is a forward-looking exercise. Given the disadvantages of analyzing historical performance data, we use Monte Carlo simulations to generate more realistic scenarios for the future behavior of our portfolios. This enables us to account for dynamic correlations between individual funds and specific market scenarios. The outcome of this stress-testing exercise feeds back into our portfolio construction process and may lead to adjusted allocations to single funds and strategies. This approach to portfolio construction complements our manager selection process, where we strive to select managers that are able to produce positive returns in all market environments.
