Understanding Capital Efficiency

When actively trading the markets, or even passive investing for that matter, there is a main item that is often overlooked. How efficiently actual deployed capital performs.

While the main number that matters is raw P&L and whether or not an individual achieved their desired goal for a given time period, it should be closely aligned with that is how much risk was taken -- both potential and realized risk -- in order to achieve said goal.

In an effort to help our clients understand this better, we constantly strive to be transparent and accountable for our performance, good, bad or otherwise.

While we do focus on the Alpha we can produce versus the broader market, we also want to look at how efficiently any deployed capital performs over moderate and longer time horizons. All of our strategies utilize the Risk Budget concept, which in practice is the total amount of drawdown that a strategy may see, but in reality it equates to starting account size and more often referred to as a 'Risk Unit'.

It is the total capital allotted to a strategy to properly execute it and allow for trades to be taken and the ebb and flow of wins and losses. Or said another way, room for the strategy to breathe over longer periods and the natural ups and downs that take place with any strategy.

For our current strategies this amount is $25,000 for Pure Alpha, Gamma Nova and Hedge Fusion and $50,000 for Futures Focus. Some clients use these starting amounts and some choose to start with or scale to a higher amount of these (2x, 5x, 10x, etc.)

Regardless of the actual amounts, on a given week anywhere from 5% to 20% of these total amounts may be deployed across various trades. And in some regimes going forward even more if recent performance has been strong and a decent amount of what is deployed is recent profits (minimal to no risk on base capital). We refer to the risk taken or capital deployed at any given time as Absolute Risk, but for the purposes of this it can also be called Potential Volatility. Then we have what we call Realized Volatility. This is simply the maximum drawdown that a given strategy has endured to-date.

Based on this, and similar to our Asymmetric Efficiency Index (AEI) that we developed that measures Asymmetric Outcomes (both positive and negative) on both a Weekly and Trade Level basis, we also now track Capital Effciency Factor (CEF).

What is CEF? It simply measures Annualized Return (non-compounded) versus both Potential Volatility (Maximum Capital Outlay or Max Absolute Risk) and Realized Volatility (Max Drawdown) for a given strategy.

The calculation is simple yet profound in what it reveals, both for our strategies and really any strategy on the planet.

1. Divide Annualized Return / Max Drawdown *-1

2. Divide Annualized Return / Max Capital Outlay

3. Take those two results and / 2

So if we assume a strategy total Risk Budget is $25,000. The Annualized Return is 80% ($20,000). The Maximum Drawdown is 20% ($5,000). The Maximum Capital Deployed at once is 40% ($10,000).

1. $20,000 / $5,000*-1 = 4.0

2. $20,000 / $10,000 = 2.0

3. 4.0 + 2.0 / 2 = 3.0

This equated to a CEF of 3.0 or 3.0 to 1. This means that the strategy profitability is 3x that of the risk and deployed capital composite.

To quantify this, the following scale should be used.

CEF Score	CEF Tier Details
<0	Unprofitable
0 to 2.0	Slight Capital Efficiency
2.1 to 3.0	Moderate Capital Efficiency
3.1 to 5.0	High Capital Efficiency
5.1 to 7.5	Exceptional Capital Efficiency
7.6 to 10	Elite Capital Efficiency
>10	Outlier Capital Efficiency

As a general rule and in order to truly assess a given strategy's CEF a minimum age of 6 months is desired, with > 12 months being ideal. So using Hedge Fusion and Futures Focus, both active in their current form for almost 10 months, Hedge Fusion has a CEF of 10.32 and Futures Focus comes in at 6.19.

It should be kept in mind that these scores are dynamic and will ebb and flow with time and as performance is logged.

Here are the computations for both of these strategies:

Hedge Fusion: Annualized P&L $14,360, Max Drawdown -$875, Max Capital Deployed $3,396

$14,360 / -$875 *-1 = 16.41

$14,360 / $3,396 = 4.23

16.41 + 4.23 = 20.64

20.64 / 2 = 10.32 CEF

Futures Focus: Annualized P&L $42,944, Max Drawdown -$5,800, Max Capital Deployed $8,635

$42,944 / -$5,800 *-1 = 7.4

$14,360 / $8,635 = 4.97

7.4 + 4.97 = 12.38

12.38 / 2 = 6.19 CEF

Over time, and as everything matures, I expect that all of our strategies will run CEF scores of >5, ideally north of 8.