Mean Reversion Trading Strategy

Authors: Ryan Roberts, Diego Montes, Supreet Khandate Key Results Positives: The proposed trading strategy is simple and requires the tuning of only one parameter. The Sharpe ratio, near its optimal value, is relatively insensitive to this parameter. The results reported assume we must take an active, dollar neutral, position in the market daily. When excess cash exists, we do not assume there is a risk free asset available for investing. Lifting these assumptions will improve our performance. A single-factor model, which uses a sector ETF as the factor, to regress our asset returns against proves to give the most robust performance across all of the constraints considered. Mapping our signal for each asset to a subjective view of its expected return and utilizing this view within the Black-Litterman model for portfolio allocation leads to a well diversified portfolio that builds up positions and draws down positions in a manner that does not lead to large turnover. As such, the impacts of transaction costs are mitigated. For our baseline portfolio (i.e. model can trade only 10% ADV of any asset and 10x maximum leverage), we obtain an annualized Sharpe ratio of 2.726 after transaction costs. This is compared to roughly 0.55 for an equally weighted long portfolio over the same time frame with no transaction costs. The entire process is fully-automated requiring little active management.

Negatives: An active position, either long or short, is almost always taken all of the assets in our asset universe. This may lead to scalability issues as we expand our asset universe. We consider only the basic materials industry. It remains an open question if the same results are attainable in our industries. In the testing period, we re-hedged our portfolio on a daily basis to remain dollar neutral in the market. If we lift this constraint it remains an open question how well our trading strategy will perform. This is especially true in the downturn of late 2008.

Overview and Performance Summary We propose a mean-reversion based trading strategy were the trading signals are generated from the residual returns of a multi-factor model. The multi-factor models considered in this work include: 1) a sector ETF, 2) static principal component analysis (sPCA), and 3) dynamic principal component analysis (dPCA). For comparison purposes, we also generated residual returns from two benchmark portfolios: an equally-weighted and equally-risk weighted. In all cases, once the residuals were defined, analysis was performed to map these residuals into trading signals. These trading signals were then used within the

Black-Litterman model for portfolio allocation. Each of the steps in our processed is highlighted in detail in what follows. The time frame of 01/01/2000 12/31/2005 was used to develop our trading strategy. After our analysis of various constraints, we found that the sector ETF portfolio was the most robust and used it in our testing period. This period consisted of the time frame of 01/01/2006 04/16/2010. In all of analysis and/or results presented, we include transaction costs and assume that we are charged $1 per ticket with an additional fee of $0.003/share. This is true whether we enter into a long or short position. Moreover, we assume that our initial capital is $10 million unless otherwise stated. Table 1 highlights the results of our testing period under the constraints that appear to put the most stress on our trading strategy during the training period. In all cases, we assume a dollar neutral portfolio that is re-hedged on a daily basis and that no risk-free asset is available when we have excess cash in our portfolio. Table 1: Performance results after accounting for transaction costs In all cases the portfolio is hedged daily to remain dollar neutral and an active position is maintained in the market Constraints Sharpe (annualized) Cumulative Return [%] 100% ADV / 10X max. leverage 2.647 2924.00 10% ADV / 10X max. leverage 2.726 431.00 100% ADV / 2x max. leverage 3.164 1117.00 10% ADV / 2x max. leverage 2.811 403.00 Figure 1 shows our cumulative return for $1 invested at the start of our testing period under the assumption that we are constrained to trade no more than 10% ADV on any one asset and have available a maximum of 10x leverage. For comparison purposes, we also include the cumulative return for the same $1 if it was invested in the S&P500 or the XLB (our benchmark ETF) directly. As Figure 1 indicates our trading strategy offers superior performance.

Figure 1: Cumulative return of our portfolio compared against the S&P500 and XLB. Constrained to trade 10% ADV with a maximum of 10x leverage and remain dollar neutral in the market Table 2 presents the performance of our strategy under various capacities (i.e. initial portfolio value) ranging from $1 million USD to $1 billion USD. We find that while our Sharpe ratio remains impressive it begins to degrade as we place an increasing amount of capital in our strategy. We see the same behavior with our cumulative return. Here, however, the degradation is more pronounced. That said,

with an initial capacity of $1 billion USD our strategy outperforms both the S&P500 and the XLB by a significant amount (see Figure 1). Table 2: Portfolio performance vs. capacity Constrained to trade 10% ADV with a maximum of 10x leverage and remain dollar neutral in the market Initial Portfolio Value Annualize Sharpe Ratio Cumulative Return [%] (million USD) 2.844 2900.25 1 2.726 431.00 10 2.592 140.45 50 2.483 95.40 100 2.145 55.28 250 2.131 49.63 500 1.467 43.71 1000

Data Collection and Data Cleaning Prior to explaining our trading strategy in detail, we briefly discuss our data collection and cleaning process. Data was collected for 36 stocks within the basic materials industry for the time-frame of 01/01/2000 to 04/16/2010. The stocks were chosen such that they are currently an active holding in at least one of the two primary exchange traded funds (ETFs) in the basic materials industry: the XLB and IYM and traded on our starting date of 01/01/2000. We note that this may introduce some survivorship bias into our trading strategy, which was not considered here and should be the subject of future work. Upon compiling our data, it was immediately noticed that there was a handful of dates where many assets were missing prices. These dates consisted of 02/23, 06/02, 06/09, 08/28, and 08/29 in 2000 and 02/01 in 2002. Since, the majority of these dates were in our initial backtest window for developing our factor loadings in our PCA factor models (to be discussed in defining the residuals) and all were in our training period, we simply coded our trading algorithm to neglect these dates. We again note that this may introduce some data bias; however, in this case we believe this bias is negligible. Defining the residuals Let us denote by R the return of the different stocks in our trading universe over an arbitrary oneday period. If we assume that the returns on these stocks follow a multi-factor model, then the return on asset i may be represented in the form: = +
=1

Of primary interest for our mean-reversion trading strategy is the residual term given by and to define these residuals, we considered three separate approaches. In the first approach, we regressed each of the stock returns against the returns on the XLB. We choose the XLB since both the XLB and IYM are highly correlated and the XLB had return information over our entire data collection window (the IYM started on 06/20/2000; roughly seven months after we started collecting data). Thus, the residual under this approach were defined as: = ,

The second approach we refer to as static PCA. Under static PCA, the number of factors, m, is fixed throughout and the residual is given in terms of the factor returns as follows: = Finally, the third approach we refer to as dynamic PCA. Dynamic PCA is identical to static PCA in all aspects except that instead of using a fixed number of factors on a given date, we use the number of factors required to explain a given percentage of the variability. Figure 2 demonstrates how many factors are required on each day of our training period to explain 55%, 75%, and 90% of the total variability.
=1

Figure 2: Number of PCA factors required to explain a given percentage of the total variability as a function of time. To avoid any data-mining related issues and keep trading rules as simple as possible, the last 252 trading days were used to determine the factor loadings for the two PCA approaches and the residuals was calculated for the last 60 trading days. This corresponds to roughly 1-year and 1-earnings cycle respectively. Signal Generation via the residuals Once the residuals were defined following above approaches, we converted the residuals into signals. To this end, we defined the dimensionless variable () = () [ ()] [ ()]

where () is the cumulative sum, or distance from 0, of the residual on the ith asset at time t, E[*] is the expected location of the residual, and [*] is the standard deviation of the residual. The signal, as we have defined it, measures the distance to equilibrium of the cointegrated residual in units of standard deviations. In other words how far away a given stock is from its theoretical value associated with our factor model. Signals-to-Positions (Portfolio Allocation)

For a given time point, once the above signals are generated for each asset we form a subjective view on how these assets will perform in the near future. We wish to incorporate these views into our portfolio allocation process and hence utilized the Black-Litterman framework. This was done by defining the following model parameters: 1. := the equilibrium expected return of the ith asset. This is defined by the expected return of the multifactor model (i.e. the residual is equal to 0). 2. := the covariance matrix of the asset returns calculated over the previous 60 trading days. 3. := a small constant (taken to be 0.1), which is multiplied by the covariance matrix.

4. P := an 36-by-36 (the number of assets in our trading universe) matrix indicating our views. Since our views are absolute and we have a signal on each asset, P is the identity matrix. 5. q := our subjective view on the expected asset returns. This is determined by placing the signal of each of the assets from the previous 60 trading days into buckets where each bucket is of width 0.5 (excluding the tail buckets which go from Inf to -3 and 3 to Inf). Then, we calculate the expected return of that bucket. Each asset is assigned the expected return of the bucket it maps to. 6. := identical to q, but the variance of returns as opposed to the expected return. 7. c := parameter which indicates how confident we are in our view. Large values of c (greater than 100) indicates that we are highly confident and should put more emphasis on our subject view of the expected asset returns. Small values of c (around 1) indicates that we are not confident and should put more emphasis on the equilibrium returns.

Once each of the above parameters were defined and/or calculated, we computed the updated expected return vector, , defined as follows: = [()
1

and solved the standard mean-variance optimization problem under a variety of constraints. These constraints include: trading volume constraint: we can trade at most pct_vol of the average daily trading volume over the past 20-days. For example, 10% average daily volume implies pct_vol = 0.1 leverage constraint: if we hold $1, we can trade $M long and $M short. dollar neutral constraint: after each day of trading our long and short dollars must be equal.

1 1 1 1 + ] () +

The following section highlights our analysis of these constraints for each of the three methods of generating the residuals as well as the two benchmarks. Analysis

In this section, we perform analysis on the three models proposed above as well as the two benchmarks under the constraints listed in the previous section. Throughout, we use 8 factors for the sPCA model and 55% of the total variability for the dPCA model. Moreover, the c parameter we used in the Black-Litterman model is set to 100 indicating that we are confident in our views, but not certain. This parameter is optimized in the next section and hence the earlier analysis doesnt demonstrate the optimal Sharpe ratio. All of the analysis that follows is performed in our training period and is net transaction costs. Trading Volume Constraint: Figure 3 shows the annualized Sharpe ratio of our proposed trading strategy assuming a maximum leverage of 10x as a function of maximum allowable trading volume. This constraint sets an upper limit on the maximum position we can take, either long or short, in an asset as a function of its average daily trading volume. As we can see the Sharpe ratio drops precipitously when this constraint is stringent (roughly 10% of ADV), with the ETF portfolio performing the best. As we ease up on this constraint, the Sharpe ratios more or less converge to stable values with dynamic PCA performing the best. When this constraint is stringent, it was observed that the PCA portfolios performed better than the other ETF and benchmark portfolios in general, but suffered on occasion from wild upswings and downswings degrading their Sharpe ratio. Hence, there appears to be a certain level of risk present in the PCA portfolios that is not present in the EFT portfolio. Finally, we note that the two benchmark portfolios behave in a similar manner to, but under perform, the ETF portfolio both in this analysis and the analysis that follows. Since the ETF portfolio is essentially a capitalization weighted portfolio, this result is not shocking. Thus, benchmark portfolios are excluded from further reported results.

Figure 3: Annualized Sharpe ratio as a function of tradable average daily volume Maximum Level = 10x Leverage constraint: Figure 4 shows the annualized Sharpe ratio of our proposed trading strategy assuming we are constrained to trade at most 10% ADV as a function of our maximum leverage level. As we can see the Sharpe ratio drops when no leverage is available. This is attributed to the fact that when we have a small

amount of capital we are more likely to take extreme positions as we are not as impacted by the capacity constraint. As we increase our leverage level, we begin to diversify our portfolio more and this improves our Sharpe ratio. At a certain level of leverage, however, we begin to over diversify our portfolio as opposed to investing only in the assets that give us the most promising signal. As with the capacity constraint, we find the ETF portfolio performs best. This, however, is attributed to the fact that it performs the best under the 10% ADV constraint and all portfolios behave, in first order, the same under the leverage constraint.

Figure 4: Annualized Sharpe ratio as a function of our maximum leverage level Capacity Constraint = 10% ADV Dollar neutral constraint: Table 3 shows the annualized Sharpe ratio for the various portfolios when the dollar neutral constraint is present and when it is omitted. We examine this constraint at two different levels of maximum leverage with the additional constraint of 10% ADV. As we can see, at the 2x leverage level the dollar neutral constraint can have a significant impact on our overall Sharpe ratio. At the 10x maximum leverage level, however, it doesnt appear to play a significant role. Again, the ETF portfolio yields the best results. Table 3: Annualized Sharpe ratio under the dollar neutral constraint Leverage Sharpe (dollar Sharpe (no dollar neutral neutral constraint) constraint) 2x 1.6334 2.0236 ETF 10x 1.4544 1.4573 2x 1.0467 1.1820 sPCA 10x 0.8034 0.8325 2x 0.8912 1.2745 dPCA 10x 0.8313 0.9056 Parameter Optimization

With the ETF portfolio appearing the most robust across all of the constraints considered, we moved on to optimizing the strategy under the ETF portfolio.

Optimization of the Confidence Parameter Great detail was taken throughout the development of our trading strategy to not fall victim to data-mining bias. Thus, whenever possible, simple decisions were made regarding how to set our trading parameters (e.g. examine the last earnings cycle when defining our signals). The one parameter that was unclear how to set in this manner, however, was the c parameter discussed in the section on our portfolio allocation. For this we examined a range of values for the c parameter and confirmed that the results indeed match with our intuition. Figure 5 shows the Sharpe ratio of the ETF portfolio as a function of the c parameter for three different levels of capacity constraint assuming a maximum level of leverage 10x. As we can see, the c parameter is optimal in the neighborhood of 100 to 500. This matches well with what we would expect. At low levels of c, we are saying that we are not confident in our views and we should place more emphasis on the equilibrium returns. Thus, our portfolio allocation reduces to investing in the ETF directly. As we increase c, we place more emphasis on the expected returns that we expect based on our signal analysis. If our views are correct, we place more portfolio weight on the assets that we expect to generate positive returns and our Sharpe ratio increases. At a certain level of c, however, we become too confident in our views and place all our portfolio weights into a few assets that we expect to perform well. Due to this lack of diversification, our Sharpe ratio begins to fall.

Figure 5: Annualized Sharpe ratio as a function of our confidence parameter. Constructing the expected Sharpe Optimal Portfolio All of our analysis and optimization up to this point sought to achieve an expected return on the portfolio equal to that of the bucket (as defined in our section on portfolio allocation) with the highest

expected return. This, however, is not necessarily equal to the highest expected Sharpe ratio portfolio. For our final optimization, we ran our portfolio allocation routine for ten different expected returns and selected the portfolio that offered the highest expected Sharpe ratio. This was determined from the variance delivered from our optimization routine and our modified expected return vector (again as defined in our section on portfolio allocation). Ideally, we would have solved for the optimal Sharpe portfolio directly, but this proved to sustainably increase the runtime of our optimization routine due to the increased number of constraints and decision variables. Detailed Analysis of Testing Period With the optimizations just highlighted, we ran our proposed trading strategy live in our testing period under various conditions. Table 1 and Figure 1 in the section: Overview and Performance Summary highlights our results. In this section we break down the performance of our 10% ADV / 10x maximum leverage / dollar neutral constrained portfolio. Table 4 breaks down the performance of this portfolio by six month period. The strategy performs poorly in the first six months. For all other periods, however, the portfolio performs impressively; including an annualized Sharpe ratio of 0.959 in the downturn of late 2008.

Table 4: Breakdown of performance results for the 10% ADV / 10X margin / dollar neutral constrained portfolio Time Period Sharpe (annualized) Cumulative Return [%] 01/01/2006 06/30/2006 -0.0888 0.23 07/01/2006 12/31/2006 4.134 30.93 01/01/2007 06/30/2007 2.984 25.28 07/01/2007 12/31/2007 4.524 52.01 01/01/2008 06/30/2008 2.492 26.28 07/01/2008 12/31/2008 0.959 7.91 01/01/2009 06/30/2009 3.487 20.56 07/01/2009 12/31/2009 2.968 15.63 01/01/2010 04/16/2010 5.043 12.86

Figure 6 shows a direct comparison of the cumulative returns on our strategy against the level of the VIX. It is observed that when the VIX spikes (e.g. early 2007, late 2007, and late 2008) are strategy often suffers losses. However, this is not always the case, the losses appear minor, and the portfolio is generally quick to recover. Figure 7 shows the time-series of the returns on our portfolio. While there are some points where we see large returns immediately followed by large losses (i.e. volatility clustering) and some clustering of large losses, in general we dont suffer from these effects. An interesting note is to point out what happened to our portfolio in the market downturn of late 2008. As Figure 6 and Figure 7 indicate, our portfolio we relatively flat during these events.

Figure 6: Cumulative Return vs. VIX

Figure 7: Time series of portfolio returns

For our final performance analysis, we consider the returns on our long and short holdings. Figure 9 demonstrates, there is a strong negative linear dependence (almost -1) between the returns on these holdings. In other words, for all practical purpose, our portfolio is market neutral. Regressing our short returns against our long returns produces a daily alpha for our short holdings of approximately 0.1% (or 25.2% annualized).

Figure 9: Performance Analysis of long and short portfolios.

Conclusions The trading strategy presented in this work is simple, appears robust, requires minimal active management, and offers superior returns over the market and the basic materials sector ETFs. While we expect additional analysis to offer improvements in the proposed trading strategy and additional considerations (e.g. slippage, implementation issues, etc.) to degrade our results somewhat, overall, the strategy appears quite promising and definitely merits further development.