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Historical Backtesting vs. Real-World Positions

George R. Brown School of Engineering STATISTICS. Historical Backtesting vs. Real-World Positions. SECOND EUBANK CONFERENCE: MODELING FINANCIAL MARKETS IN A WORLD OF FIAT MONEY John A. Dobelman Rice University October 18-19, 2010. Outline. The Asset Allocation Problem

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Historical Backtesting vs. Real-World Positions

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  1. George R. Brown School of Engineering STATISTICS Historical Backtesting vs. Real-World Positions SECOND EUBANK CONFERENCE: MODELING FINANCIAL MARKETS IN A WORLD OF FIAT MONEY John A. Dobelman Rice University October 18-19, 2010

  2. Outline • The Asset Allocation Problem • The Equity Portfolio • Managing the Portfolio • Conclusion and Future Work 3

  3. Asset Allocation WSJ, October 19, 2030

  4. Simplified Allocation • October 14, 2009 thru October 15, 2010: • WTC Insurance • 32,536% 6-Yr Return • Gold (Comex): • 28.2% 1-Year Return • Cotton (ICE) • 63.5% 1-Year Return • TGMP (American Power Group): • 850% 1-Yr Return • LBSV (Liberty Silver): • 9,499,900% 1-Year Return

  5. Best Allocation • Powerball ($50M Jackpot): • 4,999,999,900% 1-Day return LBSV Liberty Silver, OTC-BB 10/14/09 – 10/15/10

  6. Market Modeling • Primarily for Trading • Determine how much to produce/buy • Capacity allocation • Hedging application • Speculation! • Not Necessary Necessary for LT Holding • LT holding returns → GBM model • Given that, looking for w=(w1,…,wk)

  7. BAH ≠ BAH • Active portfolio management required • "Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.“ -DFA • Even the E-V portfolios require rebalancing to maintain MV construction • For • SBAH = BAH + DivMgt • SBAH = BAH + DivMgt + Tender • SBAH = BAH + DivMgt + Tender + Tax • SBAH = BAH + DivMgt + Tender + Tax + Realloc

  8. Come a Long Way Since 1973

  9. ACC2010 • 2010 American Control Conference • Operations to Finance: Opportunities for Control Theory and Application • Control Systems Methods in Finance: Modeling and Optimal Trading, Primbs, Stanford University, and Barmish, Univ. Wisconsin • Interfaces between control theory and finance • Dynamic hedging as a stochastic control problem • LQ and receding horizon control methodolgies

  10. That’s not All! • A model of the human as a suboptimal smoother • WB Rouse - 1974 IEEE Conference on Decision and Control, 1974 • Trading Costs Around M&A Announcements • L Mai, BF Van Ness, RA Van Ness, 1983 • Economic prediction using neural networks: The case of IBM daily stock returns • H White - Proceedings of the IEEE International Conference on …, 1988 • Applications of statistical physics to economic and financial topics • M Ausloos, N Vandewalle, P Boveroux, A - Physica A: Statistical …, 1999

  11. 1990’s - 2010 • “Chaos” in futures markets? A nonlinear dynamical analysis (1991) • Steven C. Blank, Journal of Futures Markets • Components of multifractality in high-frequency stock returns (2005) • J Kwapien; Physica A: Stat Mech & Apps • A fuzzy control model (FCM) for dynamic portfolio management • R Östermark – Fuzzy sets and Systems 1996 • Fluctuations and Market Friction in Financial Trading • Bernd Rosenow, 2001, Condensed Matter

  12. 1990’s - 2010 • Stochastic Lotka-Volterra Systems of Competing Auto-Catalytic Agents Lead Generically to Truncated Pareto Power Wealth Distribution, Truncated Levy Distribution of Market Returns, Clustered Volatility, Booms and Crashes • Sorin Solomon (Hebrew University) Submitted on 30 Mar 1998) Computational Finance 97 • THE JOINT PRICING OF VOLATILITY AND LIQUIDITY! • F. Bandi, C.E. Moise, and J. Russell,2008 • Liquidity skewness • R Roll, A Subrahmanyam - Journal of Banking & Finance, 2010

  13. 1990’s - 2010 • Idiosyncratic Volatility, Stock Market Volatility, and Expected Stock Returns • Hui Guo, Robert Savickas. Journal of Business and Economic Statistics. January 1, 2006 • A theory of power-law distributions in financial market fluctuations • X Gabaix, P Gopikrishnan, et.al. Nature 423 (2003) • On fitting the Pareto–Levy distribution to stock market index data: Selecting a suitable cutoff value • H.F. Coronel-Brizioa, and A.R. Hernández-Montoya, Physica A: Statistical Mechanics and its Applications Volume 354, 15 August 2005

  14. 1990’s - 2010 • Predicting Stock Prices Using a Hybrid Kohonen Self Organizing Map (SOM) • Afolab & Olude; System Sciences, 2007. HICSS 2007 • Examples of these methods are fuzzy logic, neural network and hybridized methods such as hybrid Kohonen self organizing map (SOM), adaptive neuro-fuzzy inference system (ANFIS) etc. • This paper presents a number of methods used to predict the stock price of the day. These methods are backpropagation, Kohonen SOM, and a hybrid Kohonen SOM...the hybrid Kohonen SOM is a better predictor compared to Kohonen SOM and backpropagation

  15. Orthodoxy • Departures from the EMH Market Portfolio • Market Ω=Ω • Departure 1 Ω=ΩE • Departure 2 Ω=ΩE\Priv • Departure 3 Ω=ΩS • Departure 4 Ω=ΩIndex • Departure 5 Ω→Your E-V portfolio, m and s • Departure 6 Ω→Your E-V portfolio, • Departure 7 Ω→ Some other portfolio P

  16. Portfolio Construction • Remark: Ω=Ωindex • Wilshire 5000, SP500, RUT3000, Value-Line, DOW30, etc., are ALL actively determined portfolios. • Only “recently” could you buy into a mutual fund/ETF which attempts to replicate these indexes • Unless you inherit a portfolio, you must create one, or build one over time.

  17. Portfolio Construction • Fundamental analysis • Slow and time-consuming • Technical Analysis • Value Line • O’Neil /Investors Business Daily • Efficacy in question • Quantitative Portfolio Management • Formulation • Management • Allows statistics-based portfolio strategies

  18. Portfolio Formulation You Must Pick 10 Stocks

  19. How Much Would You Pay?

  20. For This?

  21. Fundamental Analysis

  22. Fundamental Analysis

  23. Fundamental Approach

  24. Outliers/Outliars

  25. BAH with the Greats • Benjamin Graham • Criteria for Defensive Investor 12/31/70 • Size: 100M sales (326M today) • Financial Strength: CR 2:1, LTD<WC • Positive EPS in last 10 years • 20 years of uninterrupted dividends • Min 33% EPS growth in 10 years • PE < 15 for last 3 years average EPS • P/BV < 15-22

  26. Graham Portfolio • As of 12/31/1970, this was the portoflio • AC, American Can • T, AT&T • A, Anaconda • SWX, Swift • Z, F.W. Woolworth • Bring up to the present • 1/4/1971 - End

  27. Graham Portfolio

  28. Graham BAH Results CAGR from 1971 Thru 12/31/2009: 4.13% Thru 10/10/2010: 4.09% Original DOW 30 from 1971 Components unchanged 1956-1976 5 gone, only 14 continuously traded Original DOW 30 from 1/3/2000 Thru 10/10/2010: 4.59% Indexes from 1/3/2000 thru 10/10/10 DJIAK -0.29% DOXIK 2.04% SP50 -2.03% SP50.R -0.24%

  29. 10-Yr S&P 500 Returns

  30. 30-Yr S&P 500 Returns

  31. Horizon Dependence

  32. Benchmark Summaries

  33. Benchmarks • 50-Year Real Returns of 7% (Siegel, 2002) • 1802 – 1870 (Schwert) • 1871 – 1925 (Cowles) • 1926 – 2001 (CRSP, all NYSE/AMEX/NASD) • Post WWII 1946 – 2001 • Most inflation has been during this period

  34. Benchmarks

  35. Benchmarks

  36. Return by Period

  37. QPM • Anomalies Research • Ripe with Outperformance Goal • Market Outperformance: 433,000 • "Seeking Alpha“: 922,000 • Poor performance of mutual funds • Quantitative Portfolio Management • Matching market index • Outperforming market index • “Beat the Index”

  38. QPM • Characterized by lots of data • Long look-back periods • Backtesting • Pitfalls • Bad data • Biases • Datamining • Transaction costs

  39. Statistical QPM • Lots and lots of quantitative funds • Good job prospects, BTW: E.g., • Quantitative Portfolio Analyst - Asset Manager for a Leading Hedge Fund • Diversification and expansion has seen them create a traditional asset management fund. • New York; Up to $200k + standard benefits and excellent bonus potential • Options Strategy • Public Domain • Simugram

  40. Time Value Option Sales

  41. MaxMedian Rule

  42. Simugram

  43. Simugram

  44. Fundamentals QPM • Graham-Dodd on Steroids • Exploit available data • Try and sell for OPM • Examples: • O'Shaughnessy • Greenblatt • Homegrown • What happens in real life

  45. James P. O'Shaughnessy • c1920: Ignatius Aloysius O'Shaughnessy • $110 million, I A O'Shaughnessy Foundation • Avoided 20’s stocks, fed his own companies • 66 years > $10M > $5.4B (at 10%) • 1960: Jim O'Shaughnessy's Investment Horizon began • 1986: BA Econ, University of Minnesota • Began work at the family's VC firm • 1988: O'Shaughnessy Capital Mgmt, Inc. • Consulting to Institutional Investors

  46. O'Shaughnessy (CONT’D) • 1995: Compustat (Standard & Poor's) • 1996: Cornerstone Growth and Value Funds • 1997: "What Works on Wall Street“, RBC • 2000: Sold Cornerstone to Hennessey • $200M Assets as of 6/30/00 • 2001: Sold O'Shaughnessy Capital to BSC • About $500M • 2005: Updated WWOWS

  47. O'Shaughnessy (CONT’D) • 3Q2007: O'Shaughnessy Asset Mgmt, LLC • Unwound in BSCM sale to JPM • Taking $8B out BSAM's $44B • Strategy • Benchmark: RUT2000 • No regard for sector • Growth: EPS Growth, 52W Price Increase, P/S • Value: Div Yield, LTM P/S , LTM P/CF

  48. O'Shaughnessy (CONT’D) • Dreyfus Premier Alpha Growth Fund • 1,600 companies • 300 largest-market-cap • 130 after P/E, 52W Price Incr, then by P/S • Quarterly validation • Dumping rules • loss of 50% of market value • takeover that doesn't meet the screens' criteria • allegations of fraud • bankruptcy

  49. O'Shaughnessy-esgue • Recall 11-year benchmarks:

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