Understanding the Sharpe Ratio

How to Create High-Sharpe-Ratio Investments

Market Technicians Association 28th Annual Seminar May 14, 2004 Bob Fulks

Topics

Introduction Understanding the Sharpe Ratio Measuring the Sharpe Ratio of an Investment Measuring the Sharpe Ratio of a Trading System Creating High-Sharpe-Ratio Investments Summary

May 14, 2004

Bob Fulks 2004

Measuring Investment Performance

Prior to the 1950s

Investors measured performance only by their returns Risks were known to exist but not quantified

No objective way to measure investment advisors performance regarding risk Rules of Thumb became common

% of stocks in your portfolio should equal your age Proposed that variability of returns was equally important Began the field of Modern Portfolio Theory (MPT)

Harry Markowitz (1952)

May 14, 2004

Bob Fulks 2004

The Sharpe Ratio

Prof. William Sharpe (Stanford)

Proposed the Sharpe Ratio as the best measure of worth of an investment (1966) Derived from Modern Portfolio Theory Measures a risk-adjusted return Now widely used and misused

Markowitz & Sharpe shared a Nobel Prize in Economics (1990) for their work
Bob Fulks 2004 4

May 14, 2004

Logarithmic Price Charts

Dow Jones Industrial Average Dow Jones IndustrialAverage Linear Scale Linear Scale
14000 100000

Dow Jones Industrial Average Dow Jones Industrial Average Log Scale Log Scale

12000 10000

10000

7% per year 7% per year

1000

8000

6000

4000

5% per year
2000 0 1930

100

5% per year
1980 1990 2000 10 1930 1940 1950 1960 1970 1980 1990 2000

1940

1950

1960

1970

May 14, 2004

Bob Fulks 2004

Topics

Introduction Understanding the Sharpe Ratio Measuring the Sharpe Ratio of an Investment Measuring the Sharpe Ratio of a Trading System Creating High-Sharpe-Ratio Investments Summary

May 14, 2004

Bob Fulks 2004

Consider Three Investments

$1,000,000
Investment X Investment Y Investment Z Perfect 15%

$100,000

All average 15% per year All average 15% per year return over 30 years. return over 30 years. Which would you prefer? Which would you prefer?
$10,000 0 5 10 15
Years

20

25

30

35

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Bob Fulks 2004

Annual Returns
15%
60% 40% 20% 0% -20% -40%
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

60% 40% 20% 0% -20% -40%

Returns of investment X Returns of investment X are much more consistent are much more consistent
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

60% 40% 20% 0% -20% -40%

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

60% 40% 20% 0% -20% -40%

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

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Bob Fulks 2004

Variability = Standard Deviation

Bell-shaped curve (Normal Distribution) Bell-shaped curve (Normal Distribution)
1.2

Variability = 20% Variability = 10% Variability = 6.7%

1.0

Investment X Investment Y Investment Z

0.8

0.6

0.4

0.2

0.0 -45% -30% -15% 0% 15% Return 30% 45% 60% 75%

(Actual distribution is not strictly normal but it is a good approximation.)

May 14, 2004 Bob Fulks 2004 9

Investments in Two Dimensions

40%

Preferred Region
30%

Every investment can be Every investment can be represented by a point represented by a point in the two dimensions in the two dimensions

nr ut e R Return

20%

10%

How do we assess the desirability of each? How do we assess the desirability of each?
0% 0% 5% 10% 15% 20% 25% 30% 35% 40%

Variability Variability
May 14, 2004 Bob Fulks 2004 10

Desirability = Utility

= Standard Deviation^2 = Standard Deviation^2 = Variance = Variance

Utility = Return 0.5 * A * Variability^2 A is Risk Aversion Factor

Typical Values of A

Risk-neutral person Futures trader Young engineer Conservative investor Elderly widow

0.0 1.0 2.5 10 60

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11

Determining A
$1,000,000
Investment X Investment Y Investment Z Perfect 15%

15%

$100,000

All have been averaging 15% returns

0 5 10 15
Years

10%

$10,000 20 25 30 35

6% 0 4% 0 2% 0 0 % -0 2% -0 4%

1 0

1 1

1 2

1 3

1 4

1 5

1 6

1 7

1 8

1 9

2 0

2 1

2 2

2 3

2 4

2 5

2 6

2 7

2 8

2 9

3 0

5%

6% 0 4% 0 2% 0 0 % -0 2% -0 4%

1 0

1 1

1 2

1 3

1 4

1 5

1 6

1 7

1 8

1 9

2 0

2 1

2 2

2 3

2 4

2 5

2 6

2 7

2 8

2 9

3 0

6% 0 4% 0 2% 0 0 % -0 2% -0 4%
0 1 2 3 4 5 6 7 8 9 1 0 1 1 1 2 1 3 1 4 1 5 1 6 1 7 1 8 1 9 2 0 2 1 2 2 2 3 2 4 2 5 2 6 2 7 2 8 2 9 3 0

6% 0 4% 0 2% 0 0 % -0 2% -0 4%

15% CD 14% CD 13% CD 12% CD 11% CD 10% CD 9% CD 8% CD 7% CD 6% CD 5% CD 4% CD 3% CD 2% CD 1% CD

Investment Investment Investment Investment Investment Investment Investment Investment Investment Investment Investment Investment Investment Investment Investment
12

1 0

1 1

1 2

1 3

1 4

1 5

1 6

1 7

1 8

1 9

2 0

2 1

2 2

2 3

2 4

2 5

2 6

2 7

2 8

2 9

3 0

0%

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Bob Fulks 2004

Utility of the Three Investments

40 %

Utility = Return 0.5 * A * Variability^2 Utility = Return 0.5 * A * Variability^2 Utility = 15% --0.5 * 2.5 * 20% * 20% = 10% Utility = 15% 0.5 * 2.5 * 20% * 20% = 10%
30%

yti l i t U Utility

Elderly widow A = 60
20 %

Conservative investor A = 10

Risk-neutral A=0 Futures trader A = 1.0

X Y

10 %

Young engineer A = 2.5

0% 0%

5%

10 %

15%

20 %

25%

30%

Variability Variability
May 14, 2004 Bob Fulks 2004

Utility decreases as Utility decreases as 3 5% 40 % Variability increases Variability increases

13

Position Sizing (Using Leverage)

40 %

Dividing Account Between T-Bills and Investment Z Dividing Account Between T-Bills and Investment Z
30%

200% in Z (using margin)

nr utReturn eR

20 %

X Y

Z
100% in Z 50% T-Bills / 50% in Z

10 %

100% in T-Bills
0% 0% 5% 10 % 15% 20 %

Variability Variability
May 14, 2004

All possible combinations All possible combinations lie on a straight line. lie on3 5% straight line. a 25% 30% 40 % Where is the best point to be? Where is the best point to be?
14

Bob Fulks 2004

Position Size for Maximum Utility

40%

Utility = Return 0.5 * A * Variability^2 Utility = Return 0.5 * A * Variability^2

30%

Return / Utility

20%

X Y
Optimum

Optimum Return Utility Young engineer

10%

0% 0%

Utility widow
5% 10%

Utility Conservative investor

15% 20% 25%

Variability Variability
May 14, 2004 Bob Fulks 2004

Utility has a maximum at Utility has a maximum at some value of Variability some value of Variability
30% 3 5% 40 %

15

Optimum Return Points

40 %

Optimum Return = 10 **Variability^2 + 5% Optimum Return = 10 Variability^2 + 5%

30 %

Conservative Investor Conservative Investor

Optimum return points for Optimum return points for any value of A all lie on any value of A all lie on a curve which does not a curve which does not depend upon the investment depend upon the investment

Return / Utility

20 %

Z
Utility Conservative investor

10 %

Z
0% 0% 5% 1 0% 1 5%

Y
20% 25 %

30 %

35 %

40 %

Variability Variability
May 14, 2004 Bob Fulks 2004 16

Optimizing Position Size Graphically

Optimum Position Size Curve Optimum Position Size Curve Depends only upon Investors Depends only upon Investors Risk Aversion Factor A Risk Aversion Factor A
40% 30%

Optimum Return = A **Variability^2 + 5% Optimum Return = A Variability^2 + 5%

An Investment Vehicle An Investment Vehicle

Return Return
20%

Slope of Line = Sharpe Ratio Slope of Line = Sharpe Ratio Depends only upon Investment Depends only upon Investment Optimum position size = Optimum position size = intersection of the two intersection of the two T-Bills T-Bills
5% 10% 15% 20% 25% 30% 35% 40%

10%

0% 0%

Va ria b ility Variability

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Optimizing Leverage Graphically

40%

30%

Return Return

Achieving less return than optimum

20%

Accepting more variability risk than optimum All points not on the optimum All points not on the optimum curve achieve either less return curve achieve either less return or more risk than optimum or more risk than optimum
15% 20% 25% 30% 35% 40%

10%

T-Bills T-Bills
0% 0% 5% 10%

Va ria b ility Variability

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Sharpe Ratio = Slope of the Line

40%

Sharpe Ratio = Excess Return // Sharpe Ratio = Excess Return Variability Variability
30 %

Sharpe = 1.5 Sharpe = 1.5

Sharpe = 1.0 Sharpe = 1.0

Return

20%

Z
Sharpe = 0.5 Sharpe = 0.5
Excess Return

10%

T-Bills T-Bills
0% 0% 5% 10 %

Risk-free Return
15% 20% 25% 30 % 35% 40 %

Variability Variability
May 14, 2004 Bob Fulks 2004 19

Optimum Return for Maximum Utility

40%

Optimum Return = A * Variability^2 + 5% Optimum Return = A * Variability^2 + 5%

30%

Sharpe = 1.5 Sharpe = 1.5

Return
20%

Sharpe = 1.0 Sharpe = 1.0

10%

T-Bills T-Bills
0% 0% 5% 10%

Optimum point depends Optimum point depends only upon the Sharpe Ratio only upon the Sharpe Ratio of the investment and Sharpe = 0.5 of the investment and Sharpe = 0.5 Risk Aversion Factor A Risk Aversion Factor A
15% 20% 25% 30% 35% 40%

Variability May 14, 2004 Bob Fulks 2004 20

Return to Maximize Utility

Optimum return = (Sharpe^2) / A + risk-free rate Examples:
Investor Futures Trader Young Engineer Conservative Investor Elderly Widow A 1 2.5 10 60 0.5 30% 15% 7.5% 5.4% Sharpe Ratio 1 1.5 2 105% 230% 405% 45% 95% 165% 15% 27.5% 45% 6.7% 8.8% 11.7% 3 905% 365% 95% 20%

(Extreme returns would require unrealistic leverage so we would limit the leverage used and accept lower than optimal returns in those cases)

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What is a Good Sharpe Ratio?

Distribution of Returns
1.2 1.0 0.8 0.6 0.4 0.2 0.0 -5 -4 -3 -2 -1 0 1 2 3 4 5 6 7 Multiple of Excess Return

Sharpe = 0.5 Sharpe = 1.0 Sharpe = 1.5 Sharpe = 2.0 Sharpe = 3.0

Factor % of Years that Return < T-Bills Investment Quality

0.5 31% Poor

Sharpe Ratio 1 1.5 2 16% 7% 2.3% Decent Good Great

3 0.13% Super

(Based upon a normal distribution which is an approximation.)

May 14, 2004 Bob Fulks 2004 22

Investments with Equal Sharpe Ratios

40%

Optimum = 10 **Variability^2 + 5% Optimum = 10 Variability^2 + 5%

30%

Conservative Investor Conservative Investor

Optimum = 2.5 **Variability^2 + 5% Optimum = 2.5 Variability^2 + 5%

Young Engineer Young Engineer

Optimum = 60 * Variability^2 + 5% Optimum = 60 * Variability^2 + 5%

Elderly Widow Elderly Widow

Return
20%

Young Engineer Optimum Leverage Investments Investments Equal Sharpe Ratios Equal Sharpe Ratios

10%

T-Bills
0% 0% 5% 10%

Conservative Investor Optimum Leverage

15% 20% 25%

30%

Investments with equal Investments with equal Sharpe Ratios are Sharpe Ratios are equally useful equally useful
35% 40%

Variability Variability
May 14, 2004 Bob Fulks 2004 23

Money Management (Futures)

600%

500%

Futures Trader Futures Trader

Young Engineer Young Engineer Conservative Investor Conservative Investor

Return Return
300% 400%

Optimal Point Optimal Point (Maximum Terminal Wealth) (Maximum Terminal Wealth)

200%

100%

As position size increases a single bad loss can deplete the total account
50% 100% 150% 200% 250% 300% 350% 400% 450% 500%

0% 0%

Variability Variability
May 14, 2004 Bob Fulks 2004 24

Derivation of Equations
S = (R - F) / V U = R 0.5 A V R=SV+F U = S V + F 0.5 A V dU/dV = S A V = 0 At maximum U = Uo: Vo = S / A Ro = S / A + F R May 14, 2004o = A V + F
2 2 2 2

Where: S = Sharpe Ratio R = Return F = Risk-free Rate A = Risk aversion factor V = Variability U = Utility Ro = Optimum Return
Bob Fulks 2004 25

Fundamentals - Summary

Both Return and Variability are equally important The fundamental worth of an investment is its Sharpe Ratio (not its return) Investments with equal Sharpe Ratios are equally useful (produce the same optimum return) Optimum return increases as Sharpe Ratio squared Process:

Determine your Risk Aversion Factor A Maximize Utility by adjusting leverage for optimum return: Expected return = (Sharpe^2) / A + risk-free rate

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Caveats

Equity Curves

Charts have used past data

1,000,000

Unfortunately we must invest in the future

Y
100,000

So must estimate future Sharpe Ratio from past data Never blindly use Sharpe Ratios without checking the equity curve

10,000 0 5 10 15 Years 20 25 30

The curves shown at left have identical Sharp Ratios = 1 Must also consider the trend
27

May 14, 2004

Bob Fulks 2004

Topics

Introduction Understanding the Sharpe Ratio Measuring the Sharpe Ratio of an Investment Measuring the Sharpe Ratio of a Trading System Creating High-Sharpe-Ratio Investments Summary

May 14, 2004

Bob Fulks 2004

28

Sharpe Ratio of an Investment

Sharpe Ratio: = Annualized Excess Return Annualized Standard Deviation of Returns

Questions:

How to define Return How to compute Excess Return How to annualize measurements

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29

How to Define Return

Account value is sampled at equal time intervals (annually, monthly, weekly, etc.) If investment performance is perfectly consistent, returns for every time intervals should be equal, so that:

Standard Deviation of Returns = zero Sharpe Ratio = excess_return / zero = infinite

Return for the total period should equal the sum of the returns for each time interval

Why? Two reasons

Bob Fulks 2004 30

May 14, 2004

1. Annualizing is simple
No Compounding Required

Annualized return

= 12 * Average monthly return = 52 * Average weekly return = 253 * Average daily return = 12 * Average monthly standard deviation = 52 * Average weekly standard deviation = 253 * Average daily standard deviation
Bob Fulks 2004 31

Annualized standard deviation of returns

May 14, 2004

2. Distributions tend toward normal

Central Limit Theorem (paraphrased)

If annual return is equal to the sum of periodic (weekly, monthly) returns, then the probability distribution of the annual return will tend to be a normal distribution almost regardless of what the distribution of the periodic returns is.

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32

Central Limit Theorem - Example

Distributions
10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% 0 5 10 15 20 25 Value 30 35 40 45 50 1 Period 2 Periods 3 Periods 4 Periods 5 Periods Normal Normal Normal

Monthly return is uniform distribution = 0%, 1%, 2% 9%,10%

Equal distribution = 1/11 = 9.09% Distribution becomes normal after a few months

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33

Case 1 Fixed Trade/Account Size

Investor withdraws profits each period
20,000 18,000 16,000 14,000 12,000 10,000 0 1 2 3 Years 4 5 6

Account grows linearly

Straight line on linear chart

Value increases 1500 (15% of original $10,000) per period Return for the total time equals the sum of the returns for all time intervals Standard Deviation = Zero Sharpe Ratio =
(15% - 5%) / Zero = Infinite

Year

Value

Profit

Return

T-Bill

xReturn

0 1 2 3 4 5 6

10,000 11,500 1500 13,000 1500 14,500 1500 16,000 1500 17,500 1500 19,000 1500 90% Sum: Average: StDev: Sharpe:
May 14, 2004

15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 90.0% 15.0% 0.0%

5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 60.0% 10.0% 0.0%

#DIV/0!

Bob Fulks 2004

34

Case 1 Fixed Trade/Account Size

Investor withdraws profits each period
20,000 18,000 16,000 14,000 12,000 10,000 0 1 2 3 Years 4 5 6

Account grows linearly

Straight line on linear chart

Value increases 1500 (15% of original $10,000) per period Returns calculated wrong and not all equal Return for the total time not equals the sum of the returns for all time intervals Standard Deviation Zero Sharpe Ratio Infinite
35

Year

Value

Profit

Return

T-Bill

xReturn

0 1 2 3 4 5 6

10,000 11,500 1500 13,000 1500 14,500 1500 16,000 1500 17,500 1500 19,000 1500 90% Sum: Average: StDev: Sharpe:
May 14, 2004

15.0% 13.0% 11.5% 10.3% 9.4% 8.6% 67.9% 11.3% 2.4%

5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

10.0% 8.0% 6.5% 5.3% 4.4% 3.6% 37.9% 6.3% 2.4%

2.63

Error

Bob Fulks 2004

Case 2 Scaling Trade Size

Example: Performance of your money manager Trade size increases as account grows Consistent returns creates exponentially increasing account values Return_in_interval =
Natural_logarithm of: Value_end_of_interval Value_start_of_interval

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36

Equations (i.e.: Monthly Terms)

V12 V1 V2 V3 V12 1 + R = = ..... V V V V V 0 0 1 2 11 V12 V1 V2 V3 V12 ln(1 + R) = ln = ln + ln + ln ..... + ln V V V V V 1 2 11 0 0
R year = R1 + R2 + R3 ... + R12

Vi Ri = ln V = ln (Vi ) ln (Vi 1 ) i 1
May 14, 2004 Bob Fulks 2004 37

Case 1 Scaling Trade Size

Investor reinvests profits each period
Consistent 15% Rate of Increase

$100,000

Account grows exponentially

Straight line on logarithmic chart

$10,000 0 1 2 3 4 5
Years

10

Natural logarithm of Value increases (15%) per period Return for the total time equals the sum of the returns for all time intervals Standard Deviation = Zero Sharpe Ratio =
(15% - 5%) / Zero = Infinite

Year

Value

LN(Value)

Return

T-Bill

xReturn

0 1 2 3 4 5 6 LR: AR:

10,000 9.21 11,618 9.36 13,499 9.51 15,683 9.66 18,221 9.81 21,170 9.96 24,596 10.11 90% Sum: 146% Average: StDev: Sharpe:

15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 90.0% 15.0% 0.0%

5.0% 5.0% 5.0% 5.0% 5.0% 5.0%

10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 60.0% 10.0% 0.0%

#DIV/0!

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38

Calculating Excess Return

If you tie up money you must deduct the risk-free interest rate on that money to get the excess return Examples (assuming risk-free rate = 5%):

$100,000 stock portfolio or $100,000 managed account:

Subtract 5% of $100,000 Subtract 5% of $20,000

$20,000 futures account making $100,000 trades:

Futures account using a bond portfolio as collateral, making $100,000 trades

Subtract nothing. (No money tied up)

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39

Topics

Introduction Understanding the Sharpe Ratio Measuring the Sharpe Ratio of an Investment Measuring the Sharpe Ratio of a Trading System Creating High-Sharpe-Ratio Investments Summary

May 14, 2004

Bob Fulks 2004

40

Sharpe Ratio of a Trading System

Price Data Position Sizing Price Data Market Timing Equity Data

A trading system has two components

PS

Market Timing System

When to go Long, Short, or Flat

Position Sizing System (Money Management)

What size is each position vs. time

MT

The two are quite different Ideally we should measure performance of each separately
Bob Fulks 2004 41

May 14, 2004

Algorithm to Calculate Return

New Position? Yes Invest = Shares * Price

No

Measures Sharpe Ratio of the Market Timing system Normalizes Return to Trade Size (Invest) Eliminates position size as a factor in the measurement

AccVal Return = PrevAccVal * Ln PrevAccVal Invest

Invest = PrevAccVal
May 14, 2004 Bob Fulks 2004 42

SharpeMeasure Indicator

Timing Sharpe = 2.78 Timing Sharpe = 2.78 One bar for each sample Distribution of Returns One bar for each sample Trade Size as a Percent of Account Size Cumulative Returns

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Shares = ($10000 + NetProfit) / Price

Timing Sharpe = 2.64 Timing Sharpe = 2.64 Distribution of Returns Trade Size as a % of Account Size Cumulative Returns

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44

Shares = 100

Timing Sharpe = 2.74 Timing Sharpe = 2.74 Distribution of Returns Trade Size as a % of Account Size Cumulative Returns

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45

Shares = $100,000 / Price

Timing Sharpe = 2.78 Timing Sharpe = 2.78 Distribution of Returns Trade Size as a % of Account Size Cumulative Returns

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46

Shares = 1000 / AverageTrueRange

Timing Sharpe = 2.78 Timing Sharpe = 2.78 Distribution of Returns Trade Size as a % of Account Size Cumulative Returns

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47

Measuring Sharpe Ratio - Summary

Investment

Fixed trade/account size:

Scaling trades with account size:

Vi Vi 1 Ri = AccountSize

Vi Ri = ln V i 1 Trading System

Optimize Market Timing Sharpe Ratio first Then add Position Sizing and optimize overall Trading System Sharpe Ratio
Bob Fulks 2004 48

May 14, 2004

Cautions!

Beware of quoted Sharpe Ratio numbers you see. They are probably not correct. Prof. Sharpe described the concept, not the details of how to define everything. (Actually he didnt even call it Sharpe Ratio) There is a lot of confusion and lots of people measure it incorrectly.

(TradeStations reported value is wrong!)

May 14, 2004

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49

Topics

Introduction Understanding the Sharpe Ratio Measuring the Sharpe Ratio of an Investment Measuring the Sharpe Ratio of a Trading System Creating High-Sharpe-Ratio Investments Summary

May 14, 2004

Bob Fulks 2004

50

Creating High-Sharpe Ratio Investments

They do not occur in nature!

Buy/Hold and an Index Fund are very poor investments Improve Index Fund Based Investments with Market Timing Use Market Neutral Portfolios Use Dynamic Asset Allocation Use Other Zero-Beta Spreads Putting it all together
Bob Fulks 2004 51

Must be created using Financial Engineering

May 14, 2004

$3,478 12.1% 10.2%

$1 Red denotes my annotations

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52

4.5% (Does not include transaction costs or state taxes)

$30.35 (Less than 1% of previous chart!)

$1

Red denotes my annotations

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53

Buy/Hold - Growth At Excess-Return Rate

Real-Excess-Return = Real-Total-Return less T-Bill Return
S&P 500 Growth at Excess Return Rate 100000

Sharpe = 0.26 Sharpe = 0.62 Sharpe = 1.57 Sharpe = (0.70)

Value

10000

Sharpe = (0.41)
1000 1/35 1/40 1/45 1/50 1/55 1/60 1/65 1/70 Date 1/75 1/80

Sharpe = 0.18
1/85 1/90 1/95 1/00 1/05

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54

Buy/Hold Conclusions - Inflation Adjusted

Price Data Buy/Hold

Over 67 years, buying the S&P 500 index has been a very poor investment.

Sharpe Ratio only 0.26

BH

Equity Data

However, there are some very good and very bad intervals...

Can we identify those intervals? Isnt that Market Timing?

Bob Fulks 2004 55

May 14, 2004

But market timing doesnt work

Conventional wisdom:

Everybody know market timing doesnt work Elliot Spitzer would have you believe its illegal Missing the best 1% of days in the market wipe cout 90% of the returns

so you had better stay in no matter what

True, but
Bob Fulks 2004 56

May 14, 2004

Market Timing Study

Invest $1000 in the S&P 500 index in 1/5/70 On 4/1/01 (7902 trading days later): Value = $11,839

Average gain = 8.2%/yr Average loss = 0.3%/yr Average gain = 17.8%/yr

Missing the best 1% (79) days: Value = $894

Missing the worst 1% (79) days: Value = $206,445

What would the account be worth if we avoided all the down days over the 30+ years?

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57

Market Value vs. Days in Market

$1,894,433,971,569,410 ($1.89 million billion)

$11,839 $11,839

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58

Market Timing - Conclusions

Market timing has enormous potential

But is hard to do A trading system The Murphy Model A pattern-based system

Requires a disciplined process

Lets look at some examples

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59

Murphy Model Trading System

Based on an idea from John Murphy

50 day & 150 day moving averages if Price > both then be Long if Price < both then be Short otherwise be out of the market (Somewhat modified to reduce whipsawing)

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60

Murphy Model Nasdaq Comp Index

Averages 3 trades per year over almost 33 years

Timing Sharpe = 0.69 Timing Sharpe = 0.69

Fixed $100,000 Trade Size

May 14, 2004 Bob Fulks 2004 61

Murphy Model Nasdaq Comp Index

Murphy Model Performance 1,000,000

Adding Position Sizing

Trade Size = Account Value Account grows exponentially Return: 14.8% / Yr. Sharpe Ratio: 1.5

14.8% / Yr.
100,000

Increases Performance

10,000

Buy/Hold
1,000 01/70 01/75 01/80 01/85 01/90 01/95 01/00 01/05

Much better than Buy/Hold Conclusion:

Trade Size = Account Size

May 14, 2004 Bob Fulks 2004

Date

Even simple systems can be effective

62

Pattern-Based Trading Systems

Some systems based upon repeatable patterns Eugene Fama, Efficient Market Hypothesis.

All information on markets is widely available so the market is efficient and the price chart should be a random walk with no tradable patterns. After 40 years no one has proven the hypothesis

Now even economists are beginning to find tradable patterns

Bob Fulks 2004 63

May 14, 2004

Nasdaq 100 Index Daily Values

Do you see any patterns? Do you see any patterns?

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64

Nasdaq 100 Index 6 Bars/day

Now do you see any patterns? Now do you see any patterns?

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65

Market Patterns - Example

Top of Channel Top of Channel

Bottom of Channel Bottom of Channel

Why do markets trade in channels? Why do markets trade in channels?

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Market Timing System

Timing Sharpe = 5.40 Timing Sharpe = 5.40

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Summary - Market Timing

Is very effective for achieving high Sharpe Ratios Systems can be hard to design Day trading is a full-time job Resources:

P MT E

Price Data

Market Timing Equity Data

Commodity Trading Advisors Market timer Money Managers

www.MoniResearch.com newsletter www.SAAFTI.com (Trade Association)

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Market Neutral Portfolios

So an Index fund is a poor investment

2% to 3% real after-tax return over 78 years Daily changes can exceed 2% to 3% Sharpe Ratio = 0.26 (before taxes) Full of sound and fury, signifying (almost) nothing

And most investments tend to follow the market indices to some extent. So why not get rid of the market dependence? Result is a Market Neutral Portfolio
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A Modern Asset Allocated Portfolio

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Past Performance of the Portfolio

Modern Fund Portfolio

Fund portfolio is highly correlated with S&P 500 Index Clearly doing better than the Index What if we subtract out the S&P 500 Index component Result would be Market Neutral
71

S&P 500 Index

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Creating a Market Neutral Portfolio

14%

12%

10%

65% Funds 35% Short Sharpe = 0.78

A * Variability^2 + 3% (A = 10)

9.2% 7.3%
Return
8%

Market Neutral

100% Funds 0% Short Sharpe = 0.34

6%

4%

Funds

2%

0% Funds 100% Short

0% 0%

5%

10%

15%

20%

25%

Variability

7.7%
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12.4%
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Traditional = Index + Market Neutral

If: Traditional Portfolio Minus Index Fund = Market Neutral Portfolio

Then:

Any Traditional Portfolio

Index Fund

Plus

Market Neutral Portfolio

Optimizing this is difficult

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Optimize with Market Timing

Bob Fulks 2004

Optimize Separately
73

Optimizing Market Neutral Portfolios

ReturnPortfolio = Alpha + Beta * ReturnIndex + Noise
Market Neutral Term

Market Dependent Term

All Else

The Single Index Model of Returns (Sharpe) Strategy to Optimize Market Neutral Portfolio:

Make Alpha as high as possible Make Beta = zero Minimize the Noise term
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Returns: Stock vs. Market Index

Return_Stock = Alpha + Beta * Return_Index + Noise
Single Stock

Daily Changes Daily Changes

20% 15% 10%

Slope = Beta Slope = Beta

Return_Stock

Intercept = Alpha Intercept = Alpha

-10% -8% -6% -4% -2%

5% 0% 0% -5% 2% 4% 6% 8% 10%

Best Fit linear Best Fit linear regression line regression line

-10% -15% -20%

Return_Index

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Traditional Portfolio

Price Data P P P P P

Position Sizing is very complex because Price Data are correlated Markowitz optimization is hard to use

Position Sizing

Too many estimates required Result very sensitive to assumptions

BH E

Buy/Hold Equity Data

Diversification decreases Noise term

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Returns: Portfolio vs. Market Index

Unhedged Portfolio
20%
Return_Stock
-10% -8% -6% -4% -2% -5% -10% -15% -20%

Single Stock
20% 15% 10% 5% 0% 0% 2% 4% 6% 8% 10%

15% 10%

Return_Index

Return_Portfolio

Intercept = Alpha Intercept = Alpha

-10% -8% -6% -4% -2%

5% 0% 0% -5% -10% -15% -20% 2% 4% 6% 8% 10%

Slope = Beta Slope = Beta

Noise decreases as the Noise decreases as the square root of number of square root of number of stocks in the portfolio stocks in the portfolio

Return_Index

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Adding the Neutralizer Tool

Price Data P P P P P

Neutralizer tool

Adds short position in Index Cancels Beta of Portfolio

Position Sizing

Index Data

Neutralizer

Eliminates most day-to-day portfolio fluctuations Increases Sharpe Ratio

BH E

Buy/Hold Equity Data

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Adding the Neutralizer Tool

Hedged Portfolio
20%
Return_Portfolio
-10% -8% -6% -4% -2% -5% -10% -15% -20%

Unhedged Portfolio
20% 15% 10% 5% 0% 0% 2% 4% 6% 8% 10%

Hedged to Beta = 0 Hedged to Beta = 0 (Market Neutral) (Market Neutral)

Return_Hedged

15% 10% 5% 0%

Return_Index

-10%

-8%

-6%

-4%

-2% -5% -10% -15% -20%

0%

2%

4%

6%

8%

10%

Alpha Alpha

Return_Index

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Example: Stock Portfolio

$3,000,000

$2,500,000

Portfolio Long Short EndPoints

Return: 240% Std. Dev.: 9.2% Sharpe: 22.2

$2,000,000

$1,500,000

$1,000,000

$500,000

Past performance of our 6/19/03 portfolio as designed Past performance of our 6/19/03 portfolio as designed
$0 07/02 08/02 09/02 10/02 11/02 12/02 01/03 02/03 03/03 04/03 05/03 06/03 07/03

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Portfolio Performance - 2003

Stocks

I used this method all last year Worked well most of the time Problem:

Hedge In-sample Out-of-sample

Portfolio

Group of our stocks began dropping faster than the hedge

Design Date

Solution:

Move Neutralizer the stock level

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First Improvement
P I N P N P N P N P N

Neutralize each stock separately Resulting price data mostly uncorrelated Position Sizing become much simpler

Position Sizing

BH E

Buy/Hold Equity Data

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Daily Data Daily Data

Market

Stock

Combined

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Weekly Data Weekly Data

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Observations

Neutralized price curve:

Is much smoother Tends to trend better Does not trend consistently in either direction Add a Market Timing system for each stock

Problem:

Solution:

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Second Improvement
P I Market Timing N P N P N P N P N

Add Market Timing system for each stock

Simple since neutralized stocks trend nicely

MT

MT

MT

MT

MT

Position Sizing now combines Equity Data

Tends to be uncorrelated

Position Sizing E Equity Data

Sharpe Ratio increases as the square root of the number of stocks

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Summary Optimizing Market Neutral

For each stock, mutual fund, or ETF:

Neutralize to Beta = 0 by shorting an index-based vehicle (Bear-Fund, Futures, ETFs, Options, etc.) Apply a trading system to create rising equity curve

Combine resulting equity curves with a Position Sizing process

Tends to be simple since all components are uncorrelated The diversification further increases Sharpe Ratio
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Dynamic Asset Allocation (DAA)

Asset Allocation well known technique to reduce portfolio risk How can we improve it? Solution:

Dynamic Asset Allocation between asset classes Vary the mix adaptively to maximize Sharpe Ratio Use short positions to become market neutral
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Dynamic Asset Allocation (DAA)

Chart shows which asset classes did best in each year Intended message:

PS

PL

Hold a little bit of each asset oclass all the time

N P
May 14, 2004

But why do that when you can measure which is doing better?

Zero Beta Spreads

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Zero Beta Spreads

Calculate zero beta spread of two indices Trend is obvious we now want to be:

Long S&P 400 Short S&P 500

Spread much smoother than either component Sharpe Ratio = 1.6

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Other Zero-Beta Spreads

There are many possible Zero-Beta spreads Exchange-traded funds are very useful

Can sell short as well as long Inherent diversification vs. stocks reduces portfolio Variability

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Exchange-Traded Fund Spread Map

Long Position

Short Position

Sharpe > 2.5 Sharpe > 2.0 Sharpe > 1.5

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Putting It All Together

Stocks or ETFs P I N P N P N P N DAA Spreads PS PL N ETF Spreads PS PL N P Index Market Timing

MT

MT

MT

MT

MT

MT

MT

Position Sizing E
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Equity Data
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But The Devil is in the Details

Beta = zero

But which Beta? Beta varies over time But which market index? Classical techniques have many flaws Signal Processing techniques are much better

Cancel Beta with a market index

Improve parameter measurements

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Parameter Measurements

Classical Techniques

Equal weighted data Lag = half of window width Noise from old data leaving window Nulls in frequency response No smoothing Emphasize recent data Less lag No noise from old data No nulls in frequency response Smoothed
96

Alpha

Signal Processing Approach

Beta

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Summary

Neutralizer removes overall market fluctuations and most correlation Trading system improves Sharpe Ratio and removes most remaining correlation Position sizing is much simpler since all components are uncorrelated Diversification further increases Sharpe Ratio as the square root of the number of components used Final portfolio is Market Neutral = Absolute Returns

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Conclusions

The Sharpe Ratio is the best quality measure of an investment High-Sharpe-Ratio investments are hard to find but can be created using Financial Engineering These techniques arent rocket science but are beyond the capabilities of the average investor

Opportunity for Advisors & Mutual/Hedge Funds? Prof. Sharpes web site: http://www.wsharpe.com Investments Bodie, Kane, & Marcus

Further reading:

My email: bfulks@alum.mit.edu
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