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This article examines how Alquant's Prisma risk indicators can strengthen equity investment strategies while answering a frequently asked question. It highlights how even a slight statistical edge can have a significant impact on performance.
One of the most frequently asked questions regarding our Prisma risk indicators is about their success rate. Unlike traditional trading signals that offer explicit buy or sell recommendations, Prisma indicators provide daily risk values ranging from 0% to 100%. This characteristic makes it challenging to define a clear "hit" or "loss."
To simplify this, we adopt a pragmatic approach: each daily return is considered a trade outcome. A positive return represents a "hit," while a negative return is classified as a "loss." This methodology provides a straightforward way to assess the effectiveness of our indicators in guiding daily trading decisions.
For this analysis, Prisma's standard combined equity risk indicator was employed. It aggregates five distinct risk indicators available on the Prisma platform, equally weighted to form a Combined Equity Risk Indicator, ranging from 0% (minimal risk) to 100% (maximum risk).
Two investment strategies were tested to address investors' frequent requests for reducing the frequency of exposure adjustments:
Long-Short Strategy:
Long-Only Strategy:
Although Prisma risk indicators can be effectively applied at lower trading frequencies (weekly to quarterly), this study assumes daily trading potential whenever the combined risk indicator crosses the established threshold levels.
Additionally, investors can further customize the rebalancing frequency by adjusting the threshold(s)—for example, opting for 50% instead of 30% or 75% instead of 60%.
Historically, these two strategies have shown a moderate yet meaningful improvement in positive trade outcomes. The hit ratio improved from 55.5% for the S&P 500 Total Return Index to 58.3% and 59.3% for the two strategies, respectively. However, the true value lies in the expected return per trade, which doubled compared to a passive buy-and-hold strategy—rising from 0.05% to 0.12% and 0.10%, respectively.
The fact that the expected daily return is twice as high is significant, as simply increasing the probability of winning could have been achieved by allocating 100% to cash at all times. However, it is important to recognize that despite doubling the expected daily return, the strategies still incur losses over 40% of the time, making them comparable to passive investment approaches in the short term.
As previously mentioned in a brief LinkedIn post, even a slight statistical edge can have a significant impact on long-term results. A great analogy is Roger Federer’s career: although he won ‘only’ 54.1% of the points he played, this small consistent edge allowed him to win approximately 82% of his matches.
If tennis isn’t your thing, consider how casinos operate. Although they have only a small statistical advantage over players—resulting in occasional daily losses—this slight edge is sufficient to ensure consistent profitability in the long run.
The table below presents the same statistics since the inception of Alquant’s Prisma risk indicators in October 2018. The statistics remain highly consistent with those analyzed for the entire period since 2008, highlighting the robustness of the approach and the edge it provides.
As mentioned in the beginning of this article, Prisma indicators provide continuous risk values rather than explicit trade signals. Ideally, these values should be used to adjust exposure progressively rather than applying rigid thresholds.
In this example, we apply the combined risk indicator to a concrete long-short equity strategy, trading futures on the S&P 500 index. The exposure is weighted linearly and continuously based on the indicator's value:
The strategy includes a 0.02% transaction cost and is rebalanced daily. While it may not significantly outperform the S&P 500 index in absolute terms, it offers superior stability and risk management.
This observation is borne out by the plot of historical drawdowns below. This plot highlights the previous study and the importance of aiming to develop a strategy that minimises the proportion of negative returns for long-term performance.
Analyzing key performance metrics reveals the strategy's strengths:
While absolute returns may not appear striking, the strategy's robust risk management and improved stability make it an attractive option. Furthermore, its low beta suggests potential for leverage if needed.
Alquant's Prisma risk indicators provide a valuable statistical edge, enabling investors to enhance their risk-adjusted returns. Even modest improvements in hit ratios and expected returns, when compounded over time, can yield significant long-term benefits. Whether used for daily trading or longer investment horizons, the indicators demonstrate robustness and reliability, offering investors an effective tool for navigating market volatility with greater confidence.
Disclaimer: This content is advertising material. This content as well as all information displayed on Prisma or any of Alquant’s websites does not constitute investment advice or recommendation, and shall not be construed as a solicitation or an offer for sale or purchase of any products, to effect any transactions or to conclude any legal act of any kind whatsoever. Past performance is not a guide to future performance.
Alquant, a Swiss Fintech and quantitative asset manager, is transforming asset management with innovative solutions. Leveraging deep financial and technological expertise, we offer a range of services including investment products, quantitative research, and software solutions, empowering financial institutions to create the financial products of the future.
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