A comment on HFT in the Economist

During my usual back-to-front reading of this week’s Economist I happened upon this article in Free Exchange.  This week’s study was a critique of high-frequency trading (HFT), with the allegation that HFT reduces liquidity; a solution from the study authors is discrete pricing intervals during market hours.

In lieu of making a comment on Economist website – somehow I was kicked out when I tried to post – I’ll put my thoughts below.

• The article cites “Flash Boys” and the study for the HFT strategy front-running.  The description in the article defines the term wrong:
  • First, front-running requires customer orders; HFT have none.
  • Second, the strategy being described is much more like latency arbitrage.  Just as Rothschild’s messengers gave an information advantage during the Battle of Waterloo, or pit traders used buddies at other exchanges (via phone) to communicate market events, today’s HFT are able to use price changes at one exchange to trigger orders at another.  Nothing nefarious; just the same as before but at higher speed.
• The ‘investor’ in the article seems to be the same as the ideal modelled by other papers: that is, some organisation/person which requires liquidity in large size, but has invested for reasons other than short-term price movements (e.g. long term investors or pension funds).  The latency arbitrage described above, and depicted erroneously in the article, doesn’t hurt the investor.  Let me explain:
  • Long-term investors require more out of winning trades than a tick or two.  That’s the margin of an HFT engaged in latency arbitrage, or indeed a market maker setting the bid/ask spread.  The spread is the cost of taking liquidity from the market maker.  If the long-term investor really cares about that tick, they should probably just lower their fees by around 1 or 2bps for their investors.
  • If the investor needs a lot of liquidity immediately, they will pay for the privilege by taking out multiple bid/ask layers in the order book.  Instead of the 1 or 2 tick spread, the investor will pay perhaps 5 or 10 ticks.  Seeing as pre-HFT market makers were routinely pricing bid/ask spreads in the 12.5 – 25 tick range, the investor is still better off with the HFT market maker.
  • This may go some way to explain why Vanguard, one of the world’s largest investment providers, is OK with HFT.
• The article and paper cites lack of market depth for a reason to curb HFT.  But with today’s technology, orders can be issued, cancelled and replaced nearly instantaneously.  That means keeping orders in the deep book (e.g. away from the National Best Bid/Offer) is inefficient (as brokers frequently require margin to be posted to cover the order) and unnecessarily risky.
  • The risk comes from the article’s depiction of ‘adverse selection’: if I have a choice between posting offers at 5 consecutive price levels, I’m going to be very mad if some investor sweeps the offer book and I get filled on all five.  I will probably lose money.  Instead, I’ll post an offer or 2, then post other offers as I see the price move.
  • So though the market seems not to have depth, a big order will still likely be executed at a near-best bid/offer, as HFTs come to make markets.  Again, better than before, where the book depth was all there was – no one could react fast enough to get a big order filled without a huge margin for the market maker.
• Finally, I’m not convinced by so much moralising over the wasted money on lightning-fast speed.  Most authors with a beef on HFT call this a waste of money; I could say the same about any purchase I wouldn’t make.  The fact is this ‘arms race’ frequently cited is actually good for everyone but the HFTs that must continually spend the money, slowly putting themselves out of business.  It’s a bit like the recent OPEC announcement, keeping production high: the only ones really hurt by the announcement are governments which rely upon oil revenues to keep finances in check.  The rest of us get an early Christmas gift.

The paper’s authors attended a CFA conference weekly, and discussed the topic.  A summary is here.  Similar to other calls to curb HFT, the solution seems awful woolly; particularly for getting rid of a system which generally works, but would require wholesale changes to obtain the desires of opponents.

End soapbox.

Another leg down for oil

Youch:

OPEC to Putin: no sympathy. Source: Amibroker.

Looks like prices at the pump have nowhere to go but down.  Thanks to typical Cournot competition resulting from lack of collusion, all the OPEC players lose.

Not even Qatar will like WTI below $71, or Brent below $75:

Agreeing to disagree = no one happy. Source: BBC News

Update: as WTI took out stops @ 69.50, nearly kissing the 69 level, we’re now kinda below the territory the pundits mentioned oil would go without an OPEC cut.  A couple thoughts:

• Wow.  Oil falls fast.
• Unlike the moves in several other commodities, I’m not convinced this oil move is principally a strong-USD bet.  I think it’s mainly just a way-oversupplied oil market with lots of players who can’t feasibly stop producing.  The countries need even the discounted revenue to maintain budgets and services.  So, for oil-consumers, this is about as close to ‘Happy Christmas from the Middle East’ as we’re going to get.

A quant’s annoyance…continuous futures contracts

Data work…. ugh. Source: Google images

Just a small vent today.  I’m deep in the middle of creating my own series of continuous futures contracts, which is both dull and so very important that there’s nothing for it.  I can understand why pre-made series (at least for intraday granularity) cost a fortune.

For those wondering what I’m talking about: futures contracts, like most derivatives, have a finite lifespan.  If I want to go long the S&P 500, I might buy a March 2015-expiry S&P 500 future.  So far, so good.  The issue comes in backtesting quant strategies: one needs to ‘stitch’ these contracts together to create one series for long-term testing purposes.

But wait.  It’s not quite that simple.  Due to various factors, one frequently comes across big price jumps between 2 futures contracts.  What to do?  Depending on the use-case, there are multiple different adjustments that might be appropriate for creating the series.  The most exotic sounding, to me, is the ‘Panama’ method…which is incidentally about the simplest adjustment out there.

Once I’m through downloading many millions of data rows, then back adjusting the futures contracts, I will finally have a time series with reasonable reliability.  Then I just need to remember to keep up the process as life continues.

Perhaps another reason to leave the futures trading to paid professionals.

Trouble getting on the housing ladder? There’s an ETF (or several) for that.

Ah, the likely murmurs of stone-faced City workers I pass in the morning: just keep earning the paycheque; have to pay the mortgage.

I’ve written before about my general thoughts on buying a house.  I was burned in the bubble-pop of 2009, so perhaps I’m jaded.  In any case, here are my general thoughts:

• Pros of buying a house
  • Decorate it as I (or more likely, my wife) see(s) fit
  • A nice feeling
  • A diversifying investment, with the opportunity for very high leverage
  • A real option: if things get very bad, I can try to convince my wife to allow a lodger or two
• Cons of buying a house
  • Continuous repairs + taxes + insurance
  • Huge capital outlay
  • Extreme illiquidity, such that valuation is very tricky and transaction costs are high. These effects are multiplied by the leverage used
  • Reduced financial and physical flexibility: harder to move for whatever reason

I like the diversifying aspect of housing, so can I get the good without the bad?  The short answer is yes, I can get the investment characteristics of housing without buying a house.  A good example is the iShares Dow Jones Real Estate ETF (IYR), which contains a basket of real estate holding companies, REITs, and developers.  The performance of the fund tracks the Case-Shiller 20-city Housing Price Index quite well:

No need for bricks or mortar. Source: Quandl and S&P.

The fund is a bit more volatile than the index, which is probably at least part due to the illiquidity of measuring house prices.  In any case, the correlation is reasonable, and the major trends are captured.  The ETF is liquid, with OK-ish liquidity on the options for those wanting a leveraged investment.

As a kicker, the dividend yield for IYR is about 3.5%; that’s probably a bit lower than the net rental yield on a buy-to-let, but at least no one calls in the middle of the night needing a toilet unblocked.

World markets say 谢谢 to China’s PBOC; grazie to Super Mario

…and it’s Groundhog Day.  Another CB steps up with monetary easing – this time China – and the markets continue their ascent.  And ‘Super’ Mario Draghi helped by hinting ECB easing will continue or grow.  Shares rejoice.

Aside from the boredom-inducing, low volatility appreciation this is bringing to risk assets, I’m frankly amazed/impressed with how well central bankers seem to have tamed equity markets.  The ‘Greenspan put‘ doesn’t even come close.

Perhaps a good reason the CBOE Skew index is remaining elevated.  Plenty of folks don’t believe this rally can continue, or at least are willing to lay down some decent put premium to insure against a collapse:

Skews me… S&P Skew index. Source: thinkorswim by TDAmeritrade.

Friday rant: Charles Schwab…wtf?

The previous few posts have been a bit heavy, so let’s change topics.  Today I read an open letter from Charles Schwab asking the Fed to raise rates ASAP.  His opinion is that retirees have been fleeced by the low rates, and are hurting to the detriment of the economy overall.  Statistics are offered aplenty, as Chuck applauds the return of normal monetary policy.

Sigh.  I’ve written about this a bit before.  A summary:

• The unconventional monetary policy wasn’t intended to redistribute from savers to borrowers, nor was it designed to hurt retirees.  The policy helped avoid catastrophic economic collapse, which would have hurt everyone.
• Savers (including yours truly) are disappointed with low interest rates.  Borrowers (including all those people now buying houses, so that house prices are back to pre-crisis levels) are very happy.  Though Chuck wants to focus on retirees’ marginal propensity to consume (i.e. they spend more than they earn), I would argue we’re about as well off with borrowers (who, by definition, spend more than they earn) having lower interest rates.
• Following the housing point: though it’s more common in the UK, there are probably a lot of US retirees relying on ‘trading down’ their housing to help fund retirement.  Thank the Fed’s low rates for high mortgage – and thus housing – affordability among younger homebuyers.  In this sense, the Fed saved retirees – not hurt them.
• Beware partial equilibrium analysis.  Higher interest rates better for the economy?  Really?  Yes, higher rates mean more interest received, but also means more interest paid.  In an environment where we want to encourage business investment and employment, higher interest rates are a bad thing.

In sum: this is the second letter written by Chuck that I have a serious issue with (the other one is this, which shows an absolute lack of information and analysis about high-frequency trading).  Why does the man insist on putting his name to such insanity??  I guess he’s getting some free press, even if it’s discouraging.

Happy weekend, everyone.

Round 3: winning the mental battle against volatility using managed futures

In the previous posts (here and here) I have illustrated a couple approaches to one of the most dangerous parts of personal investing: the mental anguish caused by volatile (equity) markets.  It’s one of the main reasons we as retail investors tend to buy high and sell low: it’s tough to watch the big oscillations that an equity portfolio experiences.

So far I’ve shown a very easy-to-implement solution (the ostrich method) and a somewhat easy approach (a leveraged investment in bonds).  Today I’ll talk about another method, which is adding an uncorrelated strategy to the equity portfolio: managed futures.

I’ve written about managed futures before.  In a nutshell, the strategies employed by these funds tend to be momentum-related, and therefore exhibit near-zero correlation with equities.  That’s about as good as diversification gets.  Let’s take a look at the managed futures index (the Barclay BTOP50) versus the S&P500 since 1997:

Better diversification = better portfolio. Source: Quandl and BarclayHedge.

A few observations:

• The performance of managed futures does indeed occur at different times than stocks.  There seems to be a toss-up whether managed futures will make money when stocks are gaining value
• A 60/40 mix of stocks and managed futures looks like better value portfolio diversification than 60/40 stocks and (unlevered) bonds.  This is due to managed futures having 3 beneficial characteristics versus bonds in the period:
  • Better returns (5% p.a. versus 1% p.a.)
  • Correlation to stocks closer to zero (-0.17 versus -0.27)
  • Volatility – and thus ‘diversification bang for the buck’ – higher (8% p.a. versus 5% p.a.)
• The 60/40 mix of stocks and managed futures seems a lot less ‘equity-like’ than the 60/40 stocks and bonds mix.  That’s the impact of the strategy diversification

So we can see that, when a material part of the portfolio is moved from equities to managed futures, the result is a better risk and return tradeoff.

Extension: let’s consider the same approach as last post, which used futures or similar to create a Triple 5-Year Note.  It turns out that a common practice among managed futures providers is targeted volatility, so we can in effect choose the amount of volatility we would like our investment in managed futures to have.  Some managers keep low volatility (e.g. 5-10% p.a.), whereas others have quite high volatility (e.g. 25-30% p.a.).  Let’s look at the effect of this on the equity/managed futures portfolio:

Higher volatility of diversifier = better diversification. Source: Quandl and BarclayHedge

We can see:

• The blue line remains the S&P500
• The purple line is the 60/40 mix of stocks and managed futures
• The green and red lines are different mixes of stocks and a theoretical managed futures manager achieving 3x the risk and return of the index (I am aware of managers who have achieved this, but I don’t think their track records are public)
• In order to make the 60/40 mix of equity and 3x managed futures seem sensible, I’ve switched to a log scale on the chart
• Two conclusions to note:
  • With the higher volatility, the 60/40 mix has pretty amazing performance, which doesn’t resemble equity very much.  So stocks have essentially become the diversifier, even though they’re a larger proportion of capital.
  • A higher volatility managed futures program means you need less capital invested to get the same diversification benefits.  In this case, switching from 60/40 to, say, 85/15 gives about the same diversification as the old managed futures case with better performance.

In sum: adding a diversifying strategy to the equity portfolio improves risk-adjusted performance quite a bit.  If you’re looking for ‘bang for the buck’, a high-volatility managed futures program should allow for a smaller capital allocation while maintaining diversification benefits.  And that should allow for less portfolio volatility overall, which helps win the mental battle.

Round 2: winning the mental battle against volatility using….volatility.

Last post addressed one way to deal with the mental anguish provided by market volatility: the ostrich method.  It’s a simple method, albeit not particularly sophisticated.  Also, the ostrich method doesn’t really help improve portfolio performance, aside from keeping the investor away from rash trading decisions.

So let’s try another way; let’s consider using market volatility as a weapon of choice against market volatility.  Let’s see how more volatility can help our portfolio weather the markets.

To conquer volatility, you must become…oh never mind. Source: Google Images.

Again, let’s focus on a concrete example:

• Another typical portfolio:
  • 60% long equities.  Proxied by S&P 500 index futures
  • 40% long bonds.  Proxied by US Treasury 5-year note futures
  • Portfolio start = Sep 1997 (earliest available data for 5-year treasury)
  • No rebalancing.  Just set and forget

And the data, with monthly views.  I’ve included a 100% equity portfolio for comparison:

Cutting volatility through diversification. Source: Quandl.

A couple observations:

1. Wow, what a run from stocks since 2008
2. Even with 60/40 portfolio balance, the portfolio looks a lot like the 100% equity portfolio.  How much diversification am I really getting?

OK, so we can show that diversification generally works to lower portfolio volatility (from about 16% p.a. with all stocks, to about 10% p.a. with 60/40 blend).  Returns are a bit lower, but risk-adjusted return is a bit higher.  What I’m not so happy with is the following:

1. My portfolio still looks very equity-like, even with 60/40
2. This diversification is expensive: I’m sacrificing about 1.2% returns p.a. for the peace of mind coming with diversification

How to solve this?  Here’s one idea: suppose I created a new portfolio holding called Triple 5-year Note.  This holding is exactly the same as the 5-year note in the example, but has 3 times the return stream.  That means 3x the risk and 3x the return.  For those familiar with futures markets, this is absolutely trivial to create (provided account size is large enough to overcome lot size issues, but I digress).

Let’s now add a 3rd portfolio to the arsenal, which is 60% stocks and 40% Triple 5-year Note:

More vol = better portfolio. Source: Quandl.

A few observations:

1. The new portfolio is a bit less equity-like.  In particular, I note smoother performance around the tech bubble, and better performance around 2008
2. Diversification is cheaper.  I only sacrificed 0.8% returns p.a. for my diversification
3. The new portfolio looks less volatile than the others.  And it is: portfolio volatility is 9%, rather than 10% or 16% in the older case

So what have we done?  We’ve lowered portfolio volatility and increased returns over the old 60/40 by increasing volatility of the diversifying asset.  The 5-year note future’s volatility is about 5% p.a., which is roughly 1/3 equity volatility.  By increasing the 5-year volatility to equal that of equities, we get more diversification.  That leads to better portfolio returns, and lower portfolio risk.

Extension: some may recognise this idea as a basic concept behind products such as Risk Parity or Managed Futures strategies.  In a nutshell, the strategies equalise each asset’s volatility in the portfolio, then weight each (volatility-scaled) asset such that diversification is maximised.

How to implement: I can think of a few ways to fight portfolio volatility through this method:

1. Use futures/options – if your account is large enough (e.g. 1 E-mini S&P Future has a notional value of around $100,000, and 1 5-year note future has a notional value of about $120,000), use futures as a replacement for long stocks/bonds.  You can easily create the Triple 5-year through buying 3x the note futures.  Smaller accounts can use option strategies, such as buying deep ITM calls or vertical spreads.  NB: you’ll need to roll these derivatives each month to maintain exposure.
2. Use leveraged ETFs – for example, TYD is a 3x-levered ETF on 7-10 year US Treasuries.  It’s very illiquid, so be careful.  Vol drag might be an issue, but probably not very (volatility is low, and carry is positive).
3. Buy a mutual fund – for example, AQR has a well-known Risk Parity mutual fund which uses similar techniques as noted above.  It would mean having only this fund in the portfolio, rather than in addition to other holdings.  But it’s an easy solution.

Next time, I’ll talk about managing portfolio volatility through adding managed futures.  In particular, what adding a small allocation to the strategy, and the effect of lower/higher volatility programmes, do for portfolio performance.

Winning the mental battle against volatility – the ostrich method

I’m planning to write a few entries on a topic close to my heart (insert jokes about how I need a real life here): portfolio volatility.  To begin, let me propose an old-fashioned technique for fighting the mental anguish associated with market volatility: the ostrich method.

A keen user of the ostrich method. Source: Google Images.

Let me explain with a concrete example:

• A somewhat-typical portfolio: 
  • 50% long equities.  Proxied by the S&P 500 index
  • 30% long bonds.  Proxied by the performance of a US Treasury Bond ETF
  • 20% long commodities.  Proxied by the performance of DB Commodities ETF
  • Portfolio start = Feb 2006 (start date of commodities ETF)
  • No rebalancing.  Just set and forget

Let’s look at the data.  All return series are rescaled to begin at 100:

Portfolio performance view Feb 2006 – Nov 2014. Source: Quandl

A couple observations:

1. Nice performance.  What we all know by this point: buy and hold (if you kept through the crash of 2008) worked just fine.
2. Lots of squiggles.  That’s volatility for you.  Not just the big swings (e.g. portfolio value going from 120 -> 80 in the crash), but the regular gyrations in the market.  Look at the recent sell-off in equities at the right edge: that was indeed cringe-worthy.
3. (aside) Long commodities don’t look very good.  I’ve talked about this at length in previous posts.

Now for the ostrich method of combating market volatility.  It’s simple to explain, by devilishly difficult to enact:

• Overall theory: returns for market risk premia generally oscillate, but are positive in the long term.  Thus, if we censor intermediate observations, we can focus more on the long-term drift than the interim fluctuations.
• In plain speak: markets rise and fall a lot, but generally rise over time.  For long-term investors, it makes sense to generally ignore market prices until a decision needs to be made (e.g. rebalance or sell holdings).
• Example: Using the same portfolio shown above, let’s take a look at a couple more charts.
  • Monthly looks: suppose you just look at your monthly brokerage statement, and forget about financial headlines/news.  Here’s how your portfolio growth would look.  As an aside, look how the recent equity sell off has “disappeared” from the chart…

  • 

    Same portfolio, using monthly data. Source: Quandl.

  • Yearly looks: suppose you just look at your annual review of your account.  Here’s how the portfolio growth would look.  Notice how smooth everything looks!

  • 

    Same portfolio, using yearly close data. Source: Quandl.

In sum, and probably flogging a dead horse here: long-term investors shouldn’t care about the newspapers/financial news/websites/etc., at least insofar as making portfolio adjustments.  Diversification works, when given time.

Next time I’ll write how volatility is a very useful thing.  Sometimes we might want more, not less, volatility in our portfolios.

Great new resource for those interested in trading options

I’ve already waxed lyrical about the guys at tastytrade.  The group provides a lot of interesting research and fun (online) TV for traders of all types.

One of the more fun, and quality, bits of the show is ‘Where Do I Start’.  The series takes host-man Tom’s daughter, Case, and teaches her to trade options from the very beginning.  She has a small account, so they keep with small trades.  Anyway, they’ve recently cut out the ‘fat’ of the episodes, to leave 3-minutes of good material for each topic.  Worth study, if anyone is keen to learn options basics.