Financial Genomics
Jul 6th, 2006 | Filed under: CAPM / Alpha Theory, Portable Alpha & Alpha/Beta SeparationBy: Alpha Male
Much has been reported about the Human Genome. They say this monolithic set of codes holds the keys to life, the cure to devastating diseases and the promise of longevity. They also say each person’s genetic profile is unique. By testing one’s genes, doctors are able to provide personalized counseling and even targeting genetic therapy to modify defective genes.
Each individual’s genetic profile contains the instructions on how their bodies will react to its environment. Some will be more susceptible to certain forms of cancer. Some will catch a lot of colds and some will develop allergies to certain foods. Some will remain in thin and some will struggle with their weight for a lifetime.
In essence, your body’s overall performance throughout life is correlated to a variety of factors and stimuli. Your genetic profile can be thought of as a set of correlations to external variables (smoking, peanuts, cheesecake). Some correlations are weak and some are strong. Many are strong and negative (such as smoking).
Every investment portfolio has a similar set of correlations to various external factors. William Sharpe identified them in 1992 as manager style analysis. He regressed a set of mutual funds against 11 factors to determine how the manager’s style correlated with them. These factors were represented by 11 US Exchange Traded Funds (ETFs) ranging from bonds to stocks to more exotic assets such as mortgage-back securities.
Every mutual fund, indeed every portfolio, has a genome. And every investor should know theirs. Not knowing your fund’s (and your portfolio’s) genetic make-up will leave you susceptible to genetic diseases that will eat away at your nest-egg (such as the Asian Contagion or a spike in oil prices.)
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[…] This ariticle in Business Week illustrates clearly how hedging techniques can and will be used by individual investors in their own portfolios and it builds on many of the ideas contained in a post on this blog called “Financial Genomics”. […]
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[…] Furthermore, did the original long-only portfolio itself have a beta of one? If we assume the no-short-selling portfolio was somewhat active to start with, then its beta would likely have been different than one.  And if any active portfolio can be represented by a passive portfolio and a long/short market neutral overlay (as we have argued), then the long-only core fund itself already has “1X0/X0-like” characteristics. In the future, we’d like to see this added to the 1X0/X0 model. […]