The research of Bailey, David H. and López de Prado isn’t new, but timely considering that more and more non-professional investors are developing trading algorithms, or using 3rd-party algorithms to make investment decisions.
When selecting investment strategies, it’s tempting to focus only on those with high Sharpe ratios (SR) – the go-to measure of risk-adjusted performance. But this approach can lead to over-reliance on correlated, high-risk strategies, potentially weakening a portfolio’s long-term stability. A study titled “The Strategy Approval Decision: A Sharpe Ratio Indifference Curve Approach” (source) presents a more nuanced way of portfolio optimization, showing that a collection of low-correlation, subpar strategies can often outperform a group of high-SR strategies.
Why Low-Correlation Strategies Matter More than High SR
- Correlation Drives Portfolio Risk, Not Just Performance
- The Sharpe ratio indifference curve framework shows that the diversification benefits of adding low-correlation strategies often outweigh the performance gains from high-SR strategies. Even strategies with negative Sharpe ratios can improve the portfolio if they reduce overall risk through diversification.
- The Sharpe ratio indifference curve framework shows that the diversification benefits of adding low-correlation strategies often outweigh the performance gains from high-SR strategies. Even strategies with negative Sharpe ratios can improve the portfolio if they reduce overall risk through diversification.
- Beyond the Pitfall of High-SR Strategy Selection
- Many investors rely on fixed SR thresholds when approving new strategies, but this can be misleading. High-SR strategies often move together, exposing the portfolio to market regime risks (e.g., downturns affecting all strategies simultaneously).
- By contrast, subpar strategies with low or negative correlation—even those with mediocre SRs—can enhance the risk-adjusted performance of the overall portfolio by reducing volatility.
What the Study Teaches Us about Portfolio Construction
- Diversifying Low-Performance Strategies Pays Off
- Even seemingly poor strategies can improve portfolio outcomes if they are uncorrelated with the existing set. The study recommends shifting focus from hiring star portfolio managers (PMs) toward accumulating many average-performing PMs with low correlation, minimizing risks associated with manager turnover.
- Even seemingly poor strategies can improve portfolio outcomes if they are uncorrelated with the existing set. The study recommends shifting focus from hiring star portfolio managers (PMs) toward accumulating many average-performing PMs with low correlation, minimizing risks associated with manager turnover.
- Dynamic Strategy Approval and Adaptation
- The framework highlights the importance of continuously monitoring and approving new strategies based on how they complement the current portfolio, rather than just their standalone performance.
In the image below you can see how the number of strategies (all with SR = 0.75, and correlation value p = 0.2) affects the portfolio’s Sharpe ratio.
Practical Application: Building Resilient Investment Portfolios
Aside from obvious applications in professional strategy portfolios, this research suggests that retail investors on copy-trading platforms (e.g., eToro, Darwinex, etc.) could benefit from this approach by not subscribing to one strategy, but many uncorrelated strategies. Even if these strategies are hopelessly overfitted, or statistically not more relevant than a coin toss, de-risking by diversification can help improve the situation. Instead of chasing high-SR strategies, assembling a portfolio of random, low-correlation strategies could reduce overall risk and improve stability. Monte Carlo simulations and statistical tools like Principal Component Analysis (PCA) can help identify clusters of correlated strategies and optimize diversification early in the process.
Conclusion
The Sharpe ratio indifference curve approach fundamentally reshapes how we think about strategy approval and portfolio construction. Focusing on correlation, rather than high individual Sharpe ratios, offers a more sustainable path to long-term success. Investors should prioritize low-correlation strategies—even those with subpar performance—over heavily optimized high-SR strategies that might falter under changing market conditions.
For further insights and the full research, you can read the original paper: The Strategy Approval Decision: A Sharpe Ratio Indifference Curve Approach.
Source: Bailey, David H. and López de Prado, Marcos and López de Prado, Marcos and del Pozo, Eva, The Strategy Approval Decision: A Sharpe Ratio Indifference Curve Approach (January 1, 2013). Algorithmic Finance, (2013) 2:1, 99-109, Available at SSRN: https://ssrn.com/abstract=2003638 or http://dx.doi.org/10.2139/ssrn.2003638
