QuantDesk® Machine Learning Forecast

for the Week of February 26th, 2018

How To Use Gold As A Hedge Against Inflation

Erez Katz writes about Betting On US Defense Stocks

by Erez Katz, CEO and Co-founder of Lucena Research.

The price of gold has been traditionally perceived as inversely correlated to the price the US dollar and therefore has been used as a hedge against inflation. That correlation has held well over longer timeframes but has been proven less predictive over shorter periods. Over time, gold has been transitioned from a US dollar currency alternative into a hedge against the major indexes such as the S&P or the Dow.

Image 1: A one-year chart comparing GLD, SPDR Gold Trust (ETF) to UUP PowerShares DB US Dollar Index Bullish. See how inversely correlated the price charts are. From Google Finance.
Past performance is not indicative of future returns.

In today’s briefing, I’d like to showcase how QuantDesk® can be used effectively to construct a hedge against the S&P 500 that is based on gold, or more specifically GLD, the SPDR Gold Trust ETF.

Believe It Or Not, You Can Have Long Hedge Positions

We’ve described QuantDesk® Hedge Finder a few weeks ago, and how it’s able to construct hedges using Lucena’s pattern recognition technology. Our research indicates that selecting certain constituents that traditionally were highly correlated to gold and using them as a dynamic hedge against SPY actually produces superior results to simply buying and holding SPY. While many attribute hedges to shorting a position or buying protective puts that reduce returns in favor of lower volatility, our approach is different. We advocate identifying a set of securities that will both reduce volatility and advance returns.

Here is the game plan:

  1. Using QuantDesk portfolio replication technology, construct a replica of GLD from the Russell 1K.
  2. Use the constituents identified in step 1 as a white list from which to construct a hedge for SPY.
  3. Backtest this method over different market regimes in order to evaluate if it is effective over time.
  4. If all is good, construct a model portfolio using the same rules on which the backtest was predicated.
  5. If it continues to perform as expected, consider incorporating the above process slowly into a live portfolio.

Step 1 - Replicating GLD:

Lucena’s portfolio replicator attempts to track a time series chart (GLD in our case) by constructing a collection of securities and their allocations that together minimize tracking error over a time period (training period). In the scree below, we have ten securities from the Russell that together highly correlate to GLD or more specifically track the historical time series of GLD.

Image 2: A one-year to present chart comparing GLD to the replica portfolio. See list of selected constituents:
Not surprisingly the replication engine selected NEM and RGLD (together constitutes 68.6% of the portfolio) but also unrelated securities with much lower allocations that together fine-tunes the price correlation for GLD.

Step 2 – Hedging SPY With Our GLD Replica Constituents:

QuantDesk® Hedger wizard makes it easy to follow three simple screens of data entry after which the hedger goes to work and identifies which constituents and their allocations serve as the best hedge for a maximum projected Sharpe ratio.

Image 3: The result of the hedge finder. See at the top panel the original portfolio which consists of one position at 100% allocation namely SPY. The second panel below titled: After Hedging showcases the portfolio after hedging in which SPY was reduced to 50% allocation and the remaining 50% is distributed between the hedge positions selected by our hedge finder. As you can see in the table marked in orange, we were able to enhance the Sharpe, reduce the volatility and even slightly increase the total returns.

Step 3 – Backtesting Our Hedging Process Over Time:

Again, QuantDesk® hedge backtest wizard makes it easy to follow four simple data entry screens after which the Hedger Backtester is ready to get to work.

Image 5: Backtest hedge wizard summary screen. We are testing our hedger since 1/1/2010 to present. The portfolio rebalances every 4 weeks with up to 5 long only constituents.

After a short run, the screen updates with the following results:

Image 6: The hedging backtest results present a compelling validation. The backtest presents a higher Sharpe of 1.25 vs. 0.95 for the SPY.
A higher return of 210% vs. 187% for the SPY and a lower max drawdown of 12.91 vs. 18.64% for the SPY.
Results are net of slippage and transactions cost.
Past performance is not indicative of future returns.

Step 4 – Construct A Model Portfolio For Forward Trading

Since we were able to demonstrate a compelling case for hedging SPY using Lucena’s Hedge Finder, we can now convert the backtest to a live portfolio. It is literally a function of a single click on a button and entering the date on which we would like the model portfolio to start trading.

Conclusion

In today’s presentation, I have demonstrated how to construct a hedge for the S&P using constituents that are highly correlated to gold. QuantDesk is a powerful platform that not only aggregates alternative data sources but also enables mobilization of such data with advanced machine learning technology. All functions are driven by wizards and a highly visual interface for ease of use. We will continue to monitor our hedged portfolio and report on its progress.

Strategies Update

As in the past, we will provide weekly updates on how the model portfolios and the theme-based strategies we cover in this newsletter are performing.

Tiebreaker – Lucena’s Long/Short Equity Strategy - YTD return of 1.76% vs. benchmark of 1.81%
Image 1: Tiebreaker YTD– benchmark is VMNIX (Vanguard Market Neutral Fund Institutional Shares)
Past performance is no guarantee of future returns.

Tiebreaker has been forward traded since 2014 and to date it has enjoyed remarkably low volatility and boasts an impressive return of 54.06%, low volatility as expressed by its max-drawdown of only 6.16%, and a Sharpe of 1.86! (You can see a more detailed view of Tiebreaker’s performance below in this newsletter.)

BlackDog – Lucena’s Risk Parity - YTD return of -0.10 % vs. benchmark of -1.53%

We have recently developed a sophisticated multi-sleeve optimization engine set to provide the most suitable asset allocation for a given risk profile, while respecting multi-level allocation restriction rules.

Essentially, we strive to obtain an optimal decision while taking into consideration the trade-offs between two or more conflicting objectives. For example, if you consider a wide universe of constituents, we can find a subset selection and their respective allocations to satisfy the following:

  • Maximizing Sharpe
  • Widely diversified portfolio with certain allocation restrictions across certain asset classes, market sectors and growth/value classifications
  • Restricting volatility
  • Minimizing turnover

We can also determine the proper rebalance frequency and validate the recommended methodology with a comprehensive backtest.

Image 2: BlackDog YTD– benchmark is AQR’s Risk Parity Fund Class B
Past performance is no guarantee of future returns.

Forecasting the Top 10 Positions in the S&P

Lucena’s Forecaster uses a predetermined set of 10 factors that are selected from a large set of over 500. Self-adjusting to the most recent data, we apply a genetic algorithm (GA) process that runs over the weekend to identify the most predictive set of factors based on which our price forecasts are assessed. These factors (together called a “model”) are used to forecast the price and its corresponding confidence score of every stock in the S&P. Our machine-learning algorithm travels back in time over a look-back period (or a training period) and searches for historical states in which the underlying equities were similar to their current state. By assessing how prices moved forward in the past, we anticipate their projected price change and forecast their volatility.

The charts below represent the new model and the top 10 positions assessed by Lucena’s Price Forecaster.

Image 3: Default model for the coming week.

The top 10 forecast chart below delineates the ten positions in the S&P with the highest projected market-relative return combined with their highest confidence score.

Image 4: Forecasting the top 10 position in the S&P 500 for the coming week. The yellow stars (0 stars meaning poorest and 5 stars meaning strongest) represent the confidence score based on the forecasted volatility, while the blue stars represent backtest scoring as to how successful the machine was in forecasting the underlying asset over the lookback period -- in our case, the last 3 months.

To view a brief video of all the major functions of QuantDesk, please click on the following link:
Forecaster
QuantDesk Overview

Analysis

The table below presents the trailing 12-month performance and a YTD comparison between the two model strategies we cover in this newsletter (BlackDog and Tiebreaker), as well as the two ETFs representing the major US indexes (the DOW and the S&P).

12 Month Performance BlackDog and Tiebreaker
Image 5: Last week’s changes, trailing 12 months, and year-to-date gains/losses.
Past performance is no guarantee of future returns.

Model Tiebreaker: Lucena’s Active Long/Short US Equities Strategy:

12 Month Performance BlackDog and Tiebreaker
Tiebreaker: Paper trading model portfolio performance compared to Vanguard Market Neutral Fund since 9/1/2014. Past performance is no guarantee of future returns.

Model BlackDog 2X: Lucena’s Tactical Asset Allocation Strategy:

12 Month Performance BlackDog and Tiebreaker
BlackDog: Paper trading model portfolio performance compared to the SPY and Vanguard Balanced Index Fund since 4/1/2014. Past performance is no guarantee of future returns.

Appendix

For those of you unfamiliar with BlackDog and Tiebreaker, here is a brief overview: BlackDog and Tiebreaker are two out of an assortment of model strategies that we offer our clients. Our team of quants is constantly on the hunt for innovative investment ideas. Lucena’s model portfolios are a byproduct of some of our best research, packaged into consumable model-portfolios. The performance stats and charts presented here are a reflection of paper traded portfolios on our platform, QuantDesk®. Actual performance of our clients’ portfolios may vary as it is subject to slippage and the manager’s discretionary implementation. We will be happy to facilitate an introduction with one of our clients for those of you interested in reviewing live brokerage accounts that track our model portfolios.

Tiebreaker: Tiebreaker is an actively managed long/short equity strategy. It invests in equities from the S&P 500 and Russell 1000 and is rebalanced bi-weekly using Lucena’s Forecaster, Optimizer and Hedger. Tiebreaker splits its cash evenly between its core and hedge holdings, and its hedge positions consist of long and short equities. Tiebreaker has been able to avoid major market drawdowns while still taking full advantage of subsequent run-ups. Tiebreaker is able to adjust its long/short exposure based on idiosyncratic volatility and risk. Lucena’s Hedge Finder is primarily responsible for driving this long/short exposure tilt.

Tiebreaker Model Portfolio Performance Calculation Methodology Tiebreaker's model portfolio’s performance is a paper trading simulation and it assumes opening account balance of $1,000,000 cash. Tiebreaker started to paper trade on April 28, 2014 as a cash neutral and Bata neutral strategy. However, it was substantially modified to its current dynamic mode on 9/1/2014. Trade execution and return figures assume positions are opened at the 11:00AM EST price quoted by the primary exchange on which the security is traded and unless a stop is triggered, the positions are closed at the 4:00PM EST price quoted by the primary exchange on which the security is traded. In the case of a stop loss, a trailing 5% stop loss is imposed and is measured from the intra-week high (in the case of longs) and low (in the case of shorts). If the stop loss was triggered, an exit from the position 5% below, in the case of longs, and 5% above, in the case of shorts. Tiebreaker assesses the price at which the position is exited with the following modification: prior to March 1st, 2016, at times but not at all times, if, in consultation with a client executing the strategy, it is found that the client received a less favorable price in closing out a position when a stop loss is triggered, the less favorable price is used in determining the exit price. On September 28, 2016 we have applied new allocation algorithms to Tiebreaker and modified its rebalancing sequence to be every two weeks (10 trading days). Since March 1st, 2016, all trades are conducted automatically with no modifications based on the guidelines outlined herein. No manual modifications have been made to the gain stop prices. In instances where a position gaps through the trigger price, the initial open gapped trading price is utilized. Transaction costs are calculated as the larger of 6.95 per trade or $0.0035 * number of shares trades.

BlackDog: BlackDog is a paper trading simulation of a tactical asset allocation strategy that utilizes highly liquid ETFs of large cap and fixed income instruments. The portfolio is adjusted approximately once per month based on Lucena’s Optimizer in conjunction with Lucena’s macroeconomic ensemble voting model. Due to BlackDog’s low volatility (half the market in backtesting) we leveraged it 2X. By exposing twice its original cash assets, we take full advantage of its potential returns while maintaining market-relative low volatility and risk. As evidenced by the chart below, BlackDog 2X is substantially ahead of its benchmark (S&P 500).

In the past year, we covered QuantDesk's Forecaster, Back-tester, Optimizer, Hedger and our Event Study. In future briefings, we will keep you up-to-date on how our live portfolios are executing. We will also showcase new technologies and capabilities that we intend to deploy and make available through our premium strategies and QuantDesk® our flagship cloud-based software.
My hope is that those of you who will be following us closely will gain a good understanding of Machine Learning techniques in statistical forecasting and will gain expertise in our suite of offerings and services.

Specifically:

  • Forecaster - Pattern recognition price prediction
  • Optimizer - Portfolio allocation based on risk profile
  • Hedger - Hedge positions to reduce volatility and maximize risk adjusted return
  • Event Analyzer - Identify predictable behavior following a meaningful event
  • Back Tester - Assess an investment strategy through a historical test drive before risking capital

Your comments and questions are important to us and help to drive the content of this weekly briefing. I encourage you to continue to send us your feedback, your portfolios for analysis, or any questions you wish for us to showcase in future briefings.
Send your emails to: info@lucenaresearch.com and we will do our best to address each email received.

Please remember: This sample portfolio and the content delivered in this newsletter are for educational purposes only and NOT as the basis for one's investment strategy. Beyond discounting market impact and not counting transaction costs, there are additional factors that can impact success. Hence, additional professional due diligence and investors' insights should be considered prior to risking capital.

If you have any questions or comments on the above, feel free to contact me: erez@lucenaresearch.com

Have a great week!

Erez Katz Signature

erez@lucenaresearch.com


Disclaimer Pertaining to Content Delivered & Investment Advice

This information has been prepared by Lucena Research Inc. and is intended for informational purposes only. This information should not be construed as investment, legal and/or tax advice. Additionally, this content is not intended as an offer to sell or a solicitation of any investment product or service.

Please note: Lucena is a technology company and neither manages funds nor functions as an investment advisor. Do not take the opinions expressed explicitly or implicitly in this communication as investment advice. The opinions expressed are of the author and are based on statistical forecasting on historical data analysis.
Past performance does not guarantee future success. In addition, the assumptions and the historical data based on which opinions are made could be faulty. All results and analyses expressed are hypothetical and are NOT guaranteed. All Trading involves substantial risk. Leverage Trading has large potential reward but also large potential risk. Never trade with money you cannot afford to lose. If you are neither a registered nor a certified investment professional this information is not intended for you. Please consult a registered or a certified investment advisor before risking any capital.
The performance results for active portfolios following the screen presented here will differ from the performance contained in this report for a variety of reasons, including differences related to incurring transaction costs and/or investment advisory fees, as well as differences in the time and price that securities were acquired and disposed of, and differences in the weighting of such securities. The performance results for individuals following the strategy could also differ based on differences in treatment of dividends received, including the amount received and whether and when such dividends were reinvested. Historical performance can be revisited to correct errors or anomalies and ensure it most accurately reflects the performance of the strategy.