Machine Learning

For visual risk analysis and hedge fund selection

Dr. Claus Huber, CEFA, CFA, FRM, Rodex Risk Advisers LLC, Altendorf SZ, Switzerland
Originally published in the July | August 2018 issue

One of the main principles to build portfolios of financial assets is to achieve stable long-term performance and avoid large drawdowns. This article describes how a method of Machine Learning, Kohonen’s Self-Organising Maps, can be applied to visualise risk and to build robust portfolios of hedge fund managers. Essentially, it documents a feasibility study that was conducted to gauge whether Machine Learning can add any value to the investment process of an investor in hedge funds.

Robust portfolios can be created by avoiding concentrations and by diversifying across hedge fund managers and hedge fund styles: a portfolio comprising only, for example, long/short equity managers will suffer larger drawdowns when equity markets fall than a portfolio that invests partly also, for example, in credit or macro strategies. How can we avoid concentrations in the portfolio? A statistical tool for identifying similarities in data are the Self-Organising Maps (SOM). SOM were developed in the 1980s by Teuvo Kohonen (Kohonen, 1982). They project objects onto a 2-dimensional map with similar objects being placed closely together. SOM can be used to identify similarities in risk behaviour of hedge funds: managers with similar risk behaviour and hence similar investment strategies appear on near-by units, i.e., near-by areas on the map. A potentially important feature of SOM is that they are able to exploit non-linearity in the data, as hedge funds deploy trading strategies and instruments that lead to non-linear return profiles. SOM can be interpreted by visual inspection and can process incomplete and noisy data. The tools required for Machine Learning have become commoditised, as several toolboxes are available free on the internet. All network training and calculations discussed here were conducted with the R package “kohonen”. Fig.1 shows a SOM with 5 x 5 = 25 units which was created with hedge fund return data from Oct 2009 to Sep 2013 (48 months). We call this 4-year period vintage year 2014. Vintage year 2008 would comprise the 48 monthly returns from Oct 2003 to Sep 2007, etc.

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