July 21, 2017

Post-Strategy Portfolio Analysis

Recently, I got interested in zero-beta stock trading strategies after reading on Quantopian's preference for such strategiesI always found them to be less productive profit-wise than other methods that would correlate more closely with the market. I got to dig deeper and had to change my mind.

One of Quantopian's forum members put out a zero-beta trading strategy that I found interesting as having some potential for me to modify and improve. It took a few tests to appreciate the trading logic conveyed by this strategy and see how it behaved over time.

The following is the conclusion of a series of tests and posts put on Quantopian's forum. You might need to read my last few posts to put you in context, but what is said could stand alone.

I started analyzing the impact of a trading strategy - like 78 - could have on a portfolio of trading strategies. This game requires being played for years, even decades. One has to plan for the long term.

Some assumptions will be made. But, they are generalizations and can be modified. What will be presented are simple calculations.

The market over a 20-year period can offer a 10% CAGR, on average, with reinvested dividends. It is the secular market average, but with no guarantees. Nonetheless, with this, we can make an estimate, an approximation of Quantopian's fund value might be in 20 years time: 250M*(1+0.10)^20 = 1.68B. Its fund would have grown to about $ 1.68 billion dollars. Interesting, but just average. And it took 20 years...

However, Quantopian with its approach is adding some alpha to the mix. Therefore, I raised their estimated CAGR to 15%. That is a 50% increase attributed entirely to their alpha generation. It is also better than the average fund manager out there. Under this scenario, the Quantopian fund could reach $ 4.09 billion dollars in 20 years. Their approach adding $ 2.4 billion to their fund. I would say: well worth it. Almost 10 times more than their original stake. And $ 2.4 billion is still considered money.

If they could reach a 20% net CAGR, then after 20 years their account might be at $ 9.58 billion. Much better, their efforts paid off, returning $ 7.90 billion above market average. So their quest for higher alpha was rewarded. BTW, to put this in perspective, Mr. Buffett has a near 20% CAGR. So, I see it as easily achievable using all the tools at Quantopian's disposal.

Now, let's add the impact of a single high alpha trading strategy. Say we allocate 20% to a high alpha strategy and the rest (80%) is left for the set of 10 strategies under management.

From tests 78, 75, 73 and 72 we could average out the high alpha strategy at a 50% CAGR net of all trading expenses. I have methods that would help sustain this CAGR level. Note that these tests were all done with an overcharge on commissions and slippage, as well as on its leveraging fees.

The following table looks at the various trading intervals based on an averaged 15% return on Quantopian's set of strategies with equal allocations, and the impact of an added high alpha strategy receiving a 20% allocation:

#1   High Alpha 20% Allocation on Total Portfolio
   20 pct high alpha

(click to enlarge) 

Over a 20-year period, this aggregated fund would have added 23.54% in alpha points above Quantopian's expected return, generating $165 billion more in profits due to the 20% participation of a single high powered trading strategy.

It is a totally different ball game!

I have shown at least 4 trading strategies found on Quantopian that I have cloned, modified and where I have raised their CAGR levels in the 50% range or above. From this trading strategy alone, I have generated tests: 78, 75, 73 and 72 at that level or better. These are not exceptions. It is not like saying it can not be done. A demonstration of this has already been made in prior posts.

You increase Quantopian's CAGR to 20% for its 20-year investment period and raise the participation of a single high alpha strategy to 30%. Here is what would result: 

#2   30% High Alpha Impact on Total Portfolio
   30 pct high alpha

(click to enlarge)

Increasing the high alpha participation had quite an impact on the overall picture. It alone added $ 83 billion to the fund over those 20 years. The numbers do speak for themselves.

Increasing the high alpha allocation from 20% to 30% is an administrative move; a management allocation decision taken in a boardroom. It is also independent of whatever the other trading strategies in the group did. They averaged out to a 20% net CAGR.

Some will say this is unrealistic. Yes, I could have agreed to that years ago. But I already have at least four trading strategies that could do it, and I have some more in reserve that can do better.

So, I find the above two charts not only reasonable but also feasible. And, if I can do it, then others can too.

If we look at a portfolio metric like drawdown, we expect each strategy to contribute its share. From test 78 and Quantopian's expected -0.10 drawdown, we get for the 20% allocation: 0.20*-0.195 + 0.80*-0.10 = -0.119. Adding a high alpha strategy increased the drawdown from an expected 10% to 11.9%. I think anybody can survive the added pressure.

The same calculation applies to volatility. From a Quantopian expected 0.10 for volatility, we would get, also based on test 78: 0.20*0.19 + 0.80*0.10 = 0.118. This would raise Quantopian's expected volatility from 10% to 11.8%. Again, not a major strain.

The impact of a high alpha strategy on a portfolio of strategies can be considerable as presented above. In fact, it can overwhelm its peers. Here is a look at ten similar funds to which is added a high alpha strategy. There is no loss of generalities by making STRAT-1 to 10 equal, they will average out to the same number. Using Quantopian's expected 20% average return for strategies 1 to 10, with the high alpha strategy getting a 30% allocation for its 20-year term would result in:

#3   30% High AlphAllocation Fund
   30 pct allocation

(click to enlarge)

The high alpha strategy clearly dominated all others, to such an extent that its ending weight is 0.9738 compared to the average strategy weight of 0.0026. 97.38% of the fund is now concentrated in one high performing strategy.

It made the fund what it was or what it could be. As simple as that. The program version for test 78 is just an averaging machine.

Because you provided time to a high alpha strategy, it simply came to dominate the entire portfolio to such an extent that in the end, you could almost throw away all other strategies, and it might go unnoticed.

What we would see in time is STRAT-1 to 10 having gradually decreasing weights from their initial 0.07 down to 0.0026. While the high alpha strategy would have its weight rise from 0.30 to 0.9738. In its early years, the high alpha strategy would have its higher volatility and drawdown dampened by the other strategies and still build on its inner strengths, its alpha generation capabilities.

It becomes quite understandable to seek such strategies when you look at the impact they could have in time. A couple of those in a portfolio and it would change its long term outlook considerably.

I see the quest for the high alpha strategy as warranted and more than worth it. From the expected 20% net CAGR 10-strategy portfolio, the added high alpha strategy raised the total portfolio CAGR to 41% almost all by its own. More than doubling the initial portfolio's expected 20% CAGR.

So, how much is such a stock trading strategy worth? Based on the above charts and what has been presented so far: a lot.

How much is 1 extra alpha point worth at test 78 levels? The answer is easy. You change one number in the last chart:

#4   1% Added Alpha
   1 pct alpha

(click to enlarge)

That 1% added alpha could generate $ 35.4 billion more on its own! So, yes, strive for it.

Bottom line, it is just a program, a piece of software that has for mission to average everything out, and on average take its cut out of millions of transactions.


Created... July 21,  2017 © Guy R. Fleury. All rights reserved 

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