I trade use a completely automated approach where all signals are generated by proprietary trading strategies. However, recently I encountered an challenging problem:
Imagine we have 3 Strategies that all make 5% return annually with the same volatility and they rarely trade together. The question is how to make the best use of capital to maximize the portfolio returns.
A. The naive approach is to allocate 1/3 of cash to each strategy, and we will end up with $ 1/3 * 5 + 1/3 * 5 + 1/3 * 5 = 5\% $. This is effectively the weighted average approach. It does have the merit of diversification, but the cash is undoubtedly utilized inefficiently. This is in fact the lower bond of portfolio returns.
B. Another approach is to try to share the risk capital among the 3 strategies in some efficient way. Ideally, if they never trade together and we are allocating the full capital to each strategy should any signal sets up, then we will end up the upper bond of return, which is $ 5\% * 3 = 15\%$ for the entire portfolio.
In reality, 3 strategies tend to have trades that set up together. So, what do you think is the optimal solution for achieving maximum capital utilization?
Svisstack has provided a good starting point for discussion. Now, I will refine my questions based on his reply:
How to combine signals efficiently when there are N strategies, shall we keep capital fully invested while weighting each strategy by their performance?
What type of strategies, if combined together, can yield maximum benefits? For example, shall we combine two strategies that are both based on similar hypothesis, similar holding period, or two strategies that rarely traded together regardless of other characteristics?
Is it wise to combine 2 strategies that traded on different assets?