There is an interesting New York Times article on a mathematician and cryptologist who used to work for the wildly successful hedge fund Renaissance Technologies and is now famous for decoding DNA's. This article caught my eyes because quite a few of my former colleagues from the speech recognition research group at IBM also went over to Renaissance as researchers and portfolio managers. Renaissance is an extraordinary hedge fund in Long Island that has an average annual return of 35% since 1989, after charging 5% management fee and 44% incentive fee. They profess to hire only scientists, engineers and mathematicians with as little background in finance as possible. They started off trading futures, but has since then diversified into equities models, and is reportedly raising a $100 billion fund at the moment.
A lot of people want to know the secrets of their success. From the people they hire, one can always guess. The common thread among DNA decoding, cryptography, and speech recognition is information theory, the discipline founded by legendary Bell Labs mathematician Claude Shannon. There are a few tools in information theory that have found wide-spread applications: hidden Markov model is one, expectation-maximization (EM) algorithm is another, and then of course the grandfather of prediction: Bayesian statistics. Needless to say, I have tried them all in my own trading research, but have not met much success so far. Aside from the limitations of my imagination, I suspect the reason is that these tools work much better with higher frequency data than the daily data that I have thus far worked with. Therefore I am not ready to give up yet. (Readers of my earlier article on artificial intelligence may think that I am being inconsistent here, as I was less than enthusiastic about the application of that discipline to trading. There is, however, quite a big difference between information theory and artificial intelligence. The former is characterized by sophisticated theory with very few parameters, the latter, simple theory with a lot of parameters.)
There is one published trading model that is based squarely on research in information theory. It is called Universal Portfolios, created by Stanford information theorist Prof. Thomas Cover. It is an elegant and quite intuitive model, but I don't know how well it performs under realistic conditions. I hope to write about some of my research on this and a related class of models in a future article.
Cover, Thomas M. and Thomas, Joy A. (1991), Elements of Information Theory. John Wiley & Sons, Inc.