Imagine a world with a variety of financial institutions and instruments (like securities markets and insurance contracts) that people are free to choose exactly the types of risks that they agree to accept and those that they are ready to get rid of. In such a world, we could all take the risk of losing our job or diminishing the market value of our home. Such a world would represent the ultimate theoretical case of describing the capabilities of the financial system in the field of effective risk redistribution in society.
Over the centuries, people have created various economic institutions, developed such types of contracts that would facilitate the efficient distribution of risk as much as possible by expanding the range of optimization and by increasing specialization in risk management. Insurance companies and futures markets are examples of institutions whose first and foremost function is to facilitate the redistribution of risk within the economic system.
Modern economics treats an investment portfolio as the sum of assets (stocks, real estate, currencies, etc.) that belong to one person (investor). These assets are the object of management. The investor is faced with the task of optimizing the investment portfolio. That is, the essence of management is to increase the liquidity of the investment portfolio while maintaining the level of profitability and risk.
Hedging allows you to manage a portfolio, protecting assets from adverse market events, the so-called systematic risk. It is important to understand that hedging is not a way to get additional speculative profits, but a tool to protect assets. Both private investors and large funds use hedging. Hedge funds got their name from this term, although in their deepest essence they are not always anti-risk organizations, since, on the contrary, they use an extended list of tools and aggressive tactics.
Formation of an optimal portfolio of securities
The basis of modern portfolio theory was formed by Harry Markowitz in the 1950s ideas for managing a portfolio of securities. His approach involves analyzing the expected average values and variations in the returns on financial assets and choosing, on their basis, the optimal weights with which the investor should include each security under consideration in his portfolio.
A qualitative analysis of your holdings and your risk levels can get you pretty far, but you may want to go further in order to more precisely hedge your portfolio by crunching some numbers. This is where portfolio optimization comes in.
Portfolio optimization
Portfolio optimization is a mathematical process that attempts to maximize portfolio return and minimize risk, given whatever measure of risk you choose. The risk measure may be beta, or the correlation of a security with the market under the Capital Assets Pricing Model, or it may be value at risk, the maximum dollar loss expected in a time period with a specified confidence level — say, 95 percent.
For the most part, you have to purchase the software required to do an optimization, or you have to access it through a broker or financial advisor. It’s difficult, but not impossible, to do a good optimization on your own.
If you want to try, go to http://www.excelmodeling.com/EMI_Preface.htm to see a portfolio optimization spreadsheet created by Craig Holden, author of Excel Modeling (Prentice Hall), a textbook on portfolio optimization. You (and hedge fund managers) measure risk and return historically. No matter the quality of the optimization software you purchase and the data that you put into it, the results won’t be perfect because the future will never be exactly like the past.
The software
In order to maintain risks while maximizing return, a fund manager can run a program that comes up with optimal portfolio weighting. MetaTrader 5 is popular end-to-end software for managing a hedge fund. The software is directly linked to global financial exchanges and popular liquidity providers. Single investor or a fund manager can control and restructure his business, manage risks, generate reports, receive quotes and withdraw money – within a single program.
MT5 has diverse instruments for algorithmic trading as well. Each fund trader receives access to efficient algorithmic trading tools. Using ready-made Expert Advisors enables custom modules and creation of new ones via the specialized MQL5 IDE supporting Python, R and other languages.
Bottomline
You can’t invest wisely unless you know what you’re investing in. If you don’t understand what a hedge fund manager is talking about when he’s discussing prospective asset classes or strategies, you’re more likely to make mistakes with your hard-earned money. Follow the practicals of hedge funds managers and never forget to think about the risks in advance.
