AlphaBrain by Stephen Duneier

Author:Stephen Duneier
Language: eng
Format: epub
ISBN: 9781119335917
Publisher: Wiley
Published: 2019-01-07T00:00:00+00:00

An Uncommon Solution

After eight months Jim was up $40 million. If his payout is 13%, he was looking at taking home more than $5 million. Then suddenly, without any say in the matter, management allocates another $400 million to his portfolio. It creates a very real quandary for him. The rational thing to do, of course, is increase his position size proportionally going forward. Well, that's not entirely accurate. If his objective is to maximize returns on his portfolio over time, then yes, he should make a proportional adjustment to his position sizing. However, if his objective is to maximize his take home pay over time, the rational decision may be to make no adjustment.

On January 1 the firm's and Jim's incentives and objectives were aligned which led to optimal behavior. As soon as profits or losses are generated though, they begin to diverge. When objectives diverge rational actions may diverge as well. Unless management understands the dynamic, how to monitor it, and the appropriate actions to mitigate the impact, it can lead to mistakes that reduce returns. On the other hand, if management can and does take the appropriate actions the mistakes are reduced and returns improved.

To find a simple solution, we need look no further than what happens when an investor allocates more to the fund itself. Typically, it is treated as a series. In other words, the initial $400 million investment is treated as a separate series from the additional $400 million. As of October 31, it looks like Table 9.3.

Table 9.3 The initial $400 million investment, as a separate series from the additional $400 million.

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