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A mixture of Gaussians approach to mathematical portfolio oversight: the EF3M algorithm

Marcos López de Prado and Matthew D. Foreman

Quantitative Finance, 2014, vol. 14, issue 5, 913-930

Abstract: An analogue can be made between: (a) the slow pace at which species adapt to an environment, which often results in the emergence of a new distinct species out of a once homogeneous genetic pool and (b) the slow changes that take place over time within a fund, mutating its investment style. A fund's track record provides a sort of genetic marker, which we can use to identify mutations. This has motivated our use of a biometric procedure to detect the emergence of a new investment style within a fund's track record. In doing so, we answer the question: What is the probability that a particular PM's performance is departing from the reference distribution used to allocate her capital? The EF3M algorithm, inspired by evolutionary biology, may help detect early stages of an evolutionary divergence in an investment style and trigger a decision to review a fund's capital allocation.

Date: 2014
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