Designing Robust Trend-Following System – QuantPedia

Designing Sturdy Pattern-Following System

It’s not simple to construct a strong trend-following technique that may face up to totally different tough market circumstances and convey constant outcomes. The creator of at this time’s work was not frightened by this job and delivered a full framework on the way to design a strong trend-following technique step-by-step.

The tactic presents sensitivity evaluation and robustness checks via varied time horizons and pattern decisions. It additionally accounts for transaction prices (when one rebalances usually, they creep in and eat out a big chunk of income) and takes a multi-asset strategy to maximise carefully watched danger metrics from PMs (portfolio managers).

Dobromir Tzotchev’s framework could be summarized into the next steps:

Want for a clear Pattern-following Sign: The paper proposes a trend-following time-series momentum sign primarily based on statistical idea and investigates its properties. It reconciles theoretical outcomes with stylized info about trend-following investing, together with the hyperlink to straddles and the higher efficiency of so-called “slower” alerts.

Sound Design and Prototype Answer: Primarily based on theoretical outcomes, the paper introduces a prototype trend-following resolution that makes use of a unified strategy throughout property and diversifies throughout time frames. Via simulation examples, it highlights efficiency versus benchmarks and diversification properties for long-only portfolios.

Threat Administration Methods: The paper elaborates on portfolio and danger administration for trend-following methods. It adapts risk-budgeting and Hierarchical Threat Parity (HRP) approaches to the trend-following framework. Moreover, it discusses strategies to handle transaction prices and implications of the carry element in futures and FX forwards.

Authors: Dobromir Tzotchev

Title: Designing Sturdy Pattern-following System: Behind the Scenes of Pattern-following

Hyperlink: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4677166

Summary:

Pattern-following has actively been on traders’ radar for the previous couple of many years. The J.P. Morgan primer on momentum methods (Kolanovic and Wei, 2015) supplies an in depth evaluation of the momentum methods. The present paper focuses on a concrete trend-following resolution and analyzes its properties alongside the sensible implementation.

As at all times we current a number of attention-grabbing figures and tables:

Notable quotations from the educational analysis paper:

“We begin by presenting a sign that’s primarily based on statistical speculation testing. We present that below sure circumstances the trend-following sign is the additionally the delta of a straddle. Therefore we make specific the broadly propagated hyperlink between trend- following and lengthy straddle positions (see for instance Fung and Hsieh 2011).Subsequently, we analyze the revenue drivers for the trend-following technique primarily based on the proposed sign. We present that the technique (equally to a straddle) is worthwhile every time there are tendencies in both route. Therefore we show that the so-called “CTA smile” (see for instance Hurst et. al. 2014) could be justified inside a theoretical mannequin as properly. Moreover, the technique reveals convexity. Absolutely the worth of the Sharpe ratio of the underlying asset is of essential significance for the profitability of the technique and the upper the quantity, the larger the convexity embedded within the technique. Moreover, alerts primarily based on longer estimation durations possess ceteris paribus higher profitability than alerts primarily based on shorter lookback durations.Subsequent, the time-series properties of the underlying asset are explicitly taken into consideration. We present that the autocorrelation is vital just for the profitability of alerts primarily based on brief lookback durations (sometimes lower than a month). Naturally constructive autocorrelation results in income whereas even small values of unfavorable autocorrelation induce substantial losses. However the profitability of the alerts primarily based on longer lookback durations is unaffected by the time-series properties of the underlying.

As a result of non-linear nature of the expressions for the anticipated P&L and transaction prices, it’s tough to derive the brink Sharpe ratio of the underlying that renders the profitability of a sign primarily based on a sure lookback interval. Nonetheless, numerical outcomes shed some attention-grabbing caveats for this relationship. In Determine 13 we have now plotted the Sharpe ratio primarily based on the web P&L of the trend-following technique versus the Sharpe ratio of the underlying for varied lookback durations. We use the transaction value construction for S&P and assume a each day volatility of 1% (roughly 16% annualized). It’s evident that alerts primarily based on brief time period lookbacks can solely be worthwhile if the Sharpe ratio of the asset is sort of sizable in both route. For instance, for a sign primarily based on 2 days we’d like a Sharpe ratio above 2 and beneath -2 to guarantee the profitability of the technique. For a sign primarily based on 32 days, the Sharpe ratio needs to be above 1 or beneath -1. Even a sign primarily based on a 1 12 months lookback interval requires absolutely the worth of the Sharpe ratio to be greater than 0.5 in order that profitability is assured.

Moreover, we count on the Sharpe ratio of trend-following technique to be beneath absolutely the worth of the Sharpe ratio of the asset. A large constructive or unfavorable Sharpe ratio of the underlying and long run lookback interval are each obligatory for the Sharpe ratio of the trend-following technique to exceed absolutely the worth of the Sharpe of the underlying. For instance, we’d like the Sharpe ratio of the underlying to be greater in absolute worth than 1.5 in order that trend-following is extra worthwhile than both holding or shorting the asset.If the drift of the asset is secure (stays fixed over an extended interval), it’s way more worthwhile and cost-efficient to make use of alerts primarily based on longer lookback durations. For instance, if we count on equities to exhibit a constructive drift because of the embedded fairness danger premia, it’s preferable to make use of alerts with longer lookback durations. The attraction of the shorter time period lookback durations arises in two situations. Firstly, the length of the pattern could be smaller than an extended lookback interval. For instance, if the pattern adjustments route each 6 months making use of a sign primarily based on 1 12 months lookback shall be detrimental. Secondly, throughout market reversals alerts primarily based on shorter lookback durations are extra reactive and finally mitigate the drawdowns of the slower trend-following methods.

[On Figure 21: Cumulative Performance by Asset Class] the cumulative efficiency of the benchmark strategy in varied asset courses in addition to the efficiency of the mixed portfolio are shown14. Commodities have traditionally had essentially the most interesting trend-following track-record (commodities are additionally the asset class upon which the CTA business originated). The asset class that has been traditionally been essentially the most difficult for the trend-following strategy is equities.

Along with the engaging characteristic of constructive skewness that the trend-following methods possess, trend-following methods convey substantial diversification advantages for the long-only portfolios. As we have now already proven within the theoretical sections, trend-following methods exhibit convexity and when the transfer on the draw back is sizable sufficient the return of the trend-following technique will greater than compensate the loss within the underlying. It has additionally been well-known that the magnitude of the sell-offs is often fairly sizable and due to this fact the offset with the trend-following methods is sort of interesting.To confirm this speculation empirically we have now constructed portfolios that encompass lengthy positions within the underlyings from our asset universe. The portfolios are properly focused to have an annualized volatility of 10% and make the most of the identical danger weights for the person property as in our benchmark resolution. We now have additionally constructed mixed portfolios that make investments 50% within the long-only portfolio and 50% within the trend-following system. The diversification advantages are fairly evident in all asset courses apart from fastened revenue. In fastened revenue, the directionality of the market has led to numerous overlap between the positions of the trend-following system and people of the long-only portfolio.”

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