The author of a paper that looks at how to determine optimal leverage in an investment portfolio is the 2010 first-place winner of the $10,000 Wagner Award for Advancements in Active Investment Management.
Tony Cooper, managing director of Double-Digit Numerics in Auckland, New Zealand, will receive the award Tuesday from the The National Association of Active Investment Managers (NAAIM) at its annual conference in Orlando. In their second year, NAAIM's Wagner Awards promote the effectiveness of active investment management strategies; this year's entries have come to NAAIM from all over the world.
The paper, Alpha Generation and Risk Smoothing using Volatility of Volatility, produces a formula for the optimal leverage of an investment in a given market environment by looking at volatility of volatility, vovo for short, which often isn't considered by investment managers. A manager has to consider portfolio volatility when making asset allocations for a given level of risk tolerance, and this volatility can take extreme values that depend on the vovo, Cooper says in a summary of the paper. But for any given level of risk tolerance, portfolio managers have to be more conservative the higher vovo is, and this conservativeness costs the portfolio returns.
"This has major implications for the management of balanced funds and for financial planning," Cooper says. "It seems odd that a manager may specify and stick to an asset allocation of, say 60% equities and 40% bonds because they have determined that fulfils the client's level of risk tolerance and to ignore the fact that those equities may have a volatility in some years triple the volatility in other years. Vovo management solves that problem."
The paper shows that volatility exerts a drag on leveraged investment returns, and the drag eventually overwhelms any extra return that comes from using leverage. However, Cooper produces a formula in which compound returns become a function of volatility and somewhat more predictable.
"We show that this strategy produces excess returns (alpha), giving us the upside of leverage without the downside," he says. "The method works by using higher leverage when returns compound quickly and lower leverage when they don't. Portfolio volatility is thus more efficiently budgeted out over time." Leveraged exchange-traded funds (ETFs) are used to illustrate the strategy's principles.
Cooper's firm, Double-Digit Numerics, does quantitative research and consulting in developing and applying statistical methods and models to enhance business returns. His experience includes working as a consulting statistician in the Applied Mathematics Division of the New Zealand Department of Scientific and Industrial Research and for the master's and doctorate program in statistics at Stanford University.