Fat Tails and Stop-Losses in Portable Alpha

Abstract

We investigate the optimal stop-loss on the alpha investment for a portable alpha vehicle. The optimal stop-loss maximizes investors utility of wealth for a portfolio consisting of a portable alpha fund and risk-free assets. We model the dynamics of the assets as a combination of a normal era with positive average returns and stressed era with negative average returns. We discuss the dependence of the optimal choice of stop-loss on the probability of being in the stressed era, the average return of the alpha asset in the stressed era and on the cost to liquidate the risky alpha asset.

Keywords: Portable alpha, stop-loss, regime shifts, utility, risk aversion, Sharpe ratio

JEL Classification: G00