- Speaker #0
Hello, welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper. This one really caught my eye because it tackles a question a lot of us have pondered, you know, can you build a trend following strategy, something like those, you know, those fancy commodity trading advisor funds, but using ETFs instead of futures?
- Speaker #1
That's exactly what this paper by Vojko and Pakljova sets out to do. They call it a CTA proxy, basically mimicking the essence of a CTA funds strategy. But with ETFs as the building blocks, you know, for folks who might not be comfortable diving into these sometimes complex world of futures. Right.
- Speaker #0
ETFs feel much more accessible to many investors. So what's the big idea here? Are they just trying to chase trends across a bunch of different ETFs?
- Speaker #1
Well, it's a bit more nuanced than that. They're exploring how taking different positions long and short across a variety of asset classes impacts a portfolio's performance, especially when it comes to weathering those market storms. They looked at a universe of 13 ETFs covering stocks, bonds, commodities, and even currencies, spanning all the way from 2006 to 2023. Quite a robust data set.
- Speaker #0
That's a good chunk of market history, including some wild rides. So how did they actually go about testing this? Did they just throw darts at a board of ETFs?
- Speaker #1
Not quite. They got pretty granular with their analysis. First, they calculated the daily performance of each ETF. Then they looked at different time horizons, 3, 6, 9, and 12 months to capture momentum, you know, getting a sense of the trend.
- Speaker #0
So they're not just reacting to daily price jumps, but looking at the bigger picture of how these ETFs are moving over time.
- Speaker #1
Smart. Exactly. And based on that momentum, they generated trading signals. Positive average momentum at the end of the month. Buy signal. Negative momentum. Sell or short signal.
- Speaker #0
Okay, starting to get the picture here. Buy the ones going up, sell the ones going down. Pretty classic trend following, right?
- Speaker #1
It is, but they added a twist that I found really intriguing. They used a volatility-weighted approach for allocating to these. ETFs. Essentially, they gave higher weights to the less volatile assets and lower weights to the more jumpy ones.
- Speaker #0
Ah, that makes sense. You wouldn't want to overweight those assets that could suddenly take a nosedive and throw your whole portfolio off balance.
- Speaker #1
Precisely. It's all about managing risk while still riding those trends. Now, here's where things get really interesting. They weren't afraid to test out leverage.
- Speaker #0
Leverage? Oh, you mean borrowing money to potentially juice those returns? Talk about walking a tightrope. What happened when they added that into the mix? Well,
- Speaker #1
with a 2.1 leverage ratio, essentially doubling their exposure, the strategy's annual return bumped up to a cool 8.08%. That's nothing to sneeze at. Wow,
- Speaker #0
that's a significant jump. But leverage is a double-edged sword, right? Did the risk explode as well?
- Speaker #1
It did increase, but proportionally. The Sharpe ratio, which measures risk-adjusted returns, stayed almost the same at 0.77. That means for every unit of risk they took on, they were still getting a pretty decent return.
- Speaker #0
So leverage magnified both the good and the bad, but kept the overall balance. Still, I bet a lot of listeners are thinking, hold on, isn't this just a backtest? What about the real world?
- Speaker #1
That's a totally valid point. Backtests are great for exploring ideas, but past performance doesn't guarantee future success. However, this research wasn't just a blind backtest. The researchers were very methodical in how they designed and tested this CTA proxy.
- Speaker #0
OK, break it down for me. How did they make sure this wasn't just some curve-fitting magic trick?
- Speaker #1
First, they kept their momentum calculations pretty straightforward. No fancy indicators, just using those standard look-back periods we talked about. Second, they applied the strategy to a broad universe of ETFs. not cherry picking ones that just happened to perform well during that specific time period.
- Speaker #0
So trying to make it more representative of real world conditions, not just finding the perfect combo that looked good in the rearview mirror.
- Speaker #1
Exactly. And lastly, they didn't constantly tweak the strategy's parameters. They used a consistent volatility weighted approach for allocation, resisting the temptation to over optimize.
- Speaker #0
So they were disciplined, which is arguably the most important factor in any trading strategy, right?
- Speaker #1
Absolutely. Discipline trumps any fancy algorithm.
- Speaker #0
I love it. Now. One of the things that really jumped out at me in this paper was the finding about shorting stocks. It actually didn't seem to be that beneficial, even in a trend-following context. What's the story there?
- Speaker #1
That was one of the more surprising results, for sure. You'd think that in a trend-following strategy, shorting stocks when they're going down would be a no-brainer. But it turns out the short-only stock strategy significantly underperformed compared to other short strategies in their tests.
- Speaker #0
So what's the takeaway here? Should we completely ditch the idea of shorting stocks?
- Speaker #1
Well, it's not that simple. The researchers found that while shorting stocks might have its moments, particularly during a major market crash, the cost of being wrong can really drag down your overall performance. It's like trying to time the exact peak of a mountain climb. You might get it right sometimes, but the consequences of being even slightly off can be pretty steep.
- Speaker #0
That's a great analogy. So what did they find performed better than shorting stocks, especially in those risk-off moments?
- Speaker #1
Shorting bonds and commodities actually turned out to be a more effective crisis hedge. And it didn't come with the same performance drag they saw with shorting stocks.
- Speaker #0
Interesting. So instead of fighting the generally upward trend of the stock market, this research suggests that working with the trends in bonds and commodities, especially... on the short side, might be a more efficient way to build a crisis-resistant portfolio.
- Speaker #1
That's a great way to put it. And it leads us to the researchers'proposed CTA ETF proxy strategy, which incorporates all these insights. Want to hear more about how it actually works?
- Speaker #0
Absolutely. Let's dive into the nuts and bolts of how this strategy is put together.
- Speaker #1
Okay, so they started with their universe of 13 ETFs, remember, representing those four major asset classes. Stocks, Bonds, commodities and currencies.
- Speaker #0
The nice mix to ensure diversification.
- Speaker #1
Right. Then they took daily price data for these ETFs and calculated their performance over four different look back periods. OK,
- Speaker #0
I remember that. Three, six, nine and 12 months. They were looking at how the ETFs performed over these different time frames to get a sense of the trends.
- Speaker #1
Exactly. And then came the momentum part. They averaged the performance over those four look back periods. to get a measure of the ETF's medium to long term momentum.
- Speaker #0
So they're trying to capture the overall trend, whether it's up or down, not just getting caught up in the day to day noise.
- Speaker #1
Precisely. And based on this momentum calculation, they generated those buy and sell signals. Positive momentum, buy. Negative momentum, sell.
- Speaker #0
Simple and elegant.
- Speaker #1
Right. But remember that additional layer of sophistication they added?
- Speaker #0
The volatility weighted allocation. Instead of just investing an equal amount in each ETF, They took into account the volatility of each asset.
- Speaker #1
Exactly. They assigned higher weights to the less volatile assets and lower weights to the more volatile ones.
- Speaker #0
That makes sense. You wouldn't want to overweight a volatile asset, which could suddenly make a big move and increase the risk of the entire portfolio.
- Speaker #1
Right. So to recap, their trading rules involve calculating the average momentum of the ETFs, generating those buy and sell signals based on that momentum, and then allocating to the ETFs using a volatility weighted approach to manage risk.
- Speaker #0
This is really helpful in understanding how the strategy works. Now let's talk about those backtest results.
- Speaker #1
Well, they backtested the strategy from April 10th, 2006 to February 28, 2023, a timeframe that captured some pretty significant market swings. And what did they find? The overall strategy with those long, short positions in bonds, currencies and commodities and the long only positions in stocks achieved a sharp ratio of 0.78.
- Speaker #0
It's pretty impressive. And we already know that adding a little leverage. boosted that return even more.
- Speaker #1
It did. But remember, even with leverage, that Sharpe ratio remained pretty consistent coming in at 0.77. Leverage, in this case, amplified both the potential returns and the risk proportionally.
- Speaker #0
So it's not a free lunch. Still, I'm curious to hear more about the performance of the different parts of the strategy. I mean, we talked about how shorting stocks wasn't that great. What about those other short positions?
- Speaker #1
Well, as we've been discussing, shorting bonds and commodities actually proved to be quite effective. And remember, those short positions were particularly helpful during those periods of market stress.
- Speaker #0
So it seems like the backtest results really support their idea of avoiding shorting stocks and focusing on long short positions in other asset classes.
- Speaker #1
That's the gist of it. But keep in mind, this is just scratching the surface. The research paper delves into much more detail about the different sub-strategies, the impact of leverage, and some other fascinating findings.
- Speaker #0
So for those listeners who want to really geek out on this, We definitely encourage you to check out the full paper. We'll make sure to include a link in the show notes.
- Speaker #1
Absolutely. Now, before we wrap up this part of our deep dive, I think it's worth addressing something that often comes up when discussing these kinds of quantitative strategies. What's that? The dreaded curve fitting.
- Speaker #0
Ah, yes. The bane of every quant's existence. For those who might not be familiar, curve fitting basically means tweaking a strategy until it perfectly fits past data.
- Speaker #1
Exactly. It's like finding the key that unlocks a door that's already open. It might look great in back tests, but in real world trading, it's likely to fall flat because it's been overly optimized to the past.
- Speaker #0
So how do we know that this CTA ETF proxy strategy isn't just a cleverly disguised curve fitting exercise?
- Speaker #1
That's a fair question, and it's something we always need to be wary of. But in this case, I think the researchers took some solid steps to mitigate the risk of curve fitting.
- Speaker #0
We'll talk more about that. How do they avoid falling into the curve fitting trap?
- Speaker #1
First, remember how they kept their momentum calculations pretty basic, no fancy indicators, just those standard look back periods? That helps to ensure they're not cherry picking data points to make their strategy look better than it actually is.
- Speaker #0
Okay, so keeping it simple and transparent. I like it.
- Speaker #1
Right. And they didn't just pick and choose specific ETFs. Remember, they applied the strategy to a universe of ETFs that represent broad asset classes.
- Speaker #0
So they're not just picking winners and losers. They're trying to make the strategy work across a diverse set of assets, which makes it more likely to hold up in different market environments.
- Speaker #1
Exactly. And finally, they resisted the temptation to over optimize their parameters. They used a consistent volatility weighted approach for allocation. and didn't constantly tweak the weights to chase those higher returns.
- Speaker #0
So sticking to a disciplined approach and avoiding the urge to make the back test look perfect.
- Speaker #1
Exactly. While we can never eliminate the risk of curve fitting, I think the researchers in this case took reasonable steps to minimize it. And that gives me more confidence in the potential robustness of their findings.
- Speaker #0
Makes sense. Transparency, simplicity, a disciplined approach. That's what we always look for when evaluating these research papers. Now, let's shift gears and talk about the potential benefits and drawbacks of this CTA ETF proxy strategy. Every rose has its thorns, right?
- Speaker #1
Exactly. Let's start with the good stuff. One of the most compelling benefits is the potential for crisis resilience. Remember, CTA strategies are known for their ability to navigate market downturns. And this particular strategy, with its focus on shorting bonds and commodities, reinforces that characteristic.
- Speaker #0
So it's like having a built-in shock absorber for your portfolio.
- Speaker #1
Exactly. It can potentially help mitigate losses during those periods of market turmoil, which is a valuable feature for many investors, especially those who are a little more risk averse.
- Speaker #0
And we already talked about the diversification benefits, right?
- Speaker #1
Right. By spreading investments across different asset classes, stocks, bonds, commodities and even currencies, you're reducing the impact of any single asset having a bad day. It's like that old saying, don't put all your eggs in one basket.
- Speaker #0
Wise words indeed. Now let's flip the script. What are some potential downsides to consider before jumping headfirst into this strategy?
- Speaker #1
While managing multiple asset classes can get a bit tricky, this strategy requires monitoring and rebalancing positions across all those different markets, which can be time-consuming and demands a certain level of expertise. It's not exactly a set-it-and-forget-it approach.
- Speaker #0
So you need to be actively involved, keeping an eye on things. What else?
- Speaker #1
Then there are the trading costs. Even though ETFs generally have lower expense ratios than mutual funds. You still have to pay those trading commissions, especially if you're frequently rebalancing your portfolio. Those costs can nibble away at your returns if you're not careful.
- Speaker #0
Oh, yeah. Those fees can really sneak up on you. Anything else to keep in mind?
- Speaker #1
Well, and this might seem obvious, but it's worth reiterating. Leverage can magnify losses just as easily as it magnifies gains. So even though the research showed a pretty consistent sharp error ratio with leverage. It's crucial to have a solid risk management plan in place before even considering using it.
- Speaker #0
Absolutely. Don't play with fire unless you know how to handle it. So it sounds like the CTA ETF proxy strategy offers some intriguing possibilities, crisis resilience, diversification, and even the potential for enhanced returns through leverage. But it also comes with some challenges, complexity, trading costs, and the inherent risks of leverage.
- Speaker #1
Precisely. It's all about weighing those factors carefully and deciding if the strategy fits your investment goals, your risk tolerance, and your time commitment.
- Speaker #0
Great advice. And as always, we encourage our listeners to do their own research before implementing any new trading strategy.
- Speaker #1
Absolutely. Knowledge is power, especially when it comes to your investments. Now, I think it's time we shift gears and explore some specific examples of how this strategy might play out in different market scenarios. Ready to bring this research to life.
- Speaker #0
Absolutely. Let's get concrete. After all, what good is a strategy if we don't see how it works in action?
- Speaker #1
Let's paint a picture. Imagine a sudden market downturn, maybe a sharp correction in the stock market. You know, that classic risk-off environment where investors get spooked.
- Speaker #0
Yeah, everyone running for the exits. In that scenario, our stock portion of the portfolio would likely take a hit. Remember, we're long only in stocks.
- Speaker #1
Right. Stocks tend to be volatile, especially during downturns. Right. Here's where those other components of the strategy kick in. We're also short bonds and commodities.
- Speaker #0
So if bond and commodity prices are dropping as investors seek safety, our short positions there could actually generate profits, helping to offset those stock losses.
- Speaker #1
That's the power of diversification and having both long and short positions. It's not about predicting the direction of every market. It's about positioning yourself to potentially benefit from different moves.
- Speaker #0
It's like having a toolbox with a variety of tools. You know, you might not need every tool for every job, but having the right ones gives you flexibility.
- Speaker #1
Great analogy. Now let's switch gears. Imagine inflation starts rising significantly. You know, prices of goods and services climbing rapidly.
- Speaker #0
OK, so a different kind of economics pressure. What happens to our portfolio then?
- Speaker #1
Well, in an inflationary environment, bonds, especially those long term bonds, often take a hit.
- Speaker #0
Why is that?
- Speaker #1
When inflation heats up, central banks usually raise interest rates to cool down the economy. And that can push bond prices lower, particularly for bonds with longer maturities.
- Speaker #0
Ah, so our short positions in bonds could potentially profit in that scenario.
- Speaker #1
Exactly. And commodities often perform well during inflationary periods, you know, as raw material prices tend to increase.
- Speaker #0
But remember, we're short commodities in this strategy. Wouldn't that hurt us?
- Speaker #1
True. But don't forget about our long-only position in stocks. Companies often pass those higher costs on to consumers, so stocks might hold up or even continue to climb.
- Speaker #0
So once again, it's about that balance between the portfolio components potentially benefiting from a variety of market conditions.
- Speaker #1
Exactly. It's important to remember that no strategy is perfect, or guaranteed to be profitable in every scenario. There will always be periods of drawdowns and underperformance.
- Speaker #0
That's the reality of trading. The key is to have a strategy that makes sense, is well researched, and is implemented with discipline and risk management.
- Speaker #1
Absolutely. This CTA ETF proxy strategy aims to achieve that. It's not about trying to time the market perfectly or predict every twist and turn. It's about building a robust portfolio that can weather different storms and hopefully generate consistent returns over the long run.
- Speaker #0
That's what we all want. Before we wrap up our discussion, I'd love to hear some practical tips for putting this strategy into action.
- Speaker #1
Great point. First and foremost, choosing the right ETFs is critical. The researchers used a specific set of 13 ETFs, but you might consider others that better align with your own investment goals and risk tolerance.
- Speaker #0
So do your homework when selecting ETFs. Don't just blindly follow the research.
- Speaker #1
Exactly. And don't forget about those trading costs we discussed earlier. Frequent rebalancing can chip away at your returns if you're not careful. Choose a brokerage with low commissions and consider those bid ask spreads on the ETFs you're trading.
- Speaker #0
Cost management is so important. A few cents here and there can really add up over time.
- Speaker #1
And finally, I can't overemphasize the importance of risk management, especially if you're considering leverage. Leverage can be powerful, but it needs to be used wisely.
- Speaker #0
Set those risk limits, use stop loss orders and don't overextend yourself.
- Speaker #1
Right. Remember, trading is a marathon, not a sprint. Make informed decisions. manage risk effectively and stay disciplined.
- Speaker #0
Excellent advice. Now, I know we've covered a lot of ground today, but before we wrap up this deep dive, I'd love to take a step back and look at the bigger picture. We've talked about the mechanics of the CTA ETF proxy strategy. What does it all mean for the average investor?
- Speaker #1
That's a great question. I think the key takeaway here is that there are always alternative approaches to investing. You know, it's easy to get caught up in the hype of the day. chasing the latest hot stocks or following the crowd.
- Speaker #0
Right. Always chasing that quick profit.
- Speaker #1
But this research reminds us that there are well-researched, systematic strategies that can offer diversification, potential crisis resilience, and consistent returns over time. It's not about trying to outsmart the market or predict the future. It's about having a disciplined approach. Managing risk and sticking to your plan.
- Speaker #0
A solid plan based on solid research.
- Speaker #1
Exactly. And that's a valuable lesson for investors at all levels. Now, before we conclude, I want to leave our listeners with a final thought. The researchers focused on a specific set of ETFs and a particular time frame.
- Speaker #0
But what's really intriguing is the possibility of adapting and expanding on their approach.
- Speaker #1
Imagine exploring different asset classes, different momentum indicators. Or even incorporating machine learning to refine those trading signals.
- Speaker #0
The possibilities are endless.
- Speaker #1
That's what makes the world of quantitative trading so fascinating. It's a constant evolution, you know, a never ending quest to improve, innovate and discover new ways to approach the markets.
- Speaker #0
Like they've given us a blueprint and said, hey, here's a starting point. Now go explore, experiment and see what you can discover.
- Speaker #1
I love that spirit. It's all about pushing the boundaries and finding new ways to approach the markets. And who knows, maybe some of our listeners will take inspiration from this research and come up with their own innovative strategies.
- Speaker #0
That's what we hope for, to spark curiosity and inspire exploration. Now, before we wrap things up, I want to touch on one more point. We've talked a lot about the potential benefits of this CTA ETF proxy strategy, but it's important to acknowledge that there are also risks involved.
- Speaker #1
Absolutely. No investment strategy is a guaranteed win. And this one, like any other, comes with its own set of potential pitfalls.
- Speaker #0
Right. For example, even though the researchers took steps to mitigate curve fitting, it's always possible that their findings might not generalize perfectly to, you know, different market conditions or time periods.
- Speaker #1
That's true. Back tests are valuable tools. But they can't predict the future with 100% certainty. And let's not forget about those pesky trading costs. As we discussed, those fees can really eat into your returns if you're not careful.
- Speaker #0
Right. Choosing a cost-effective brokerage and minimizing unnecessary trading is crucial. And of course, leverage. While it can amplify potential gains, also magnifies the risk. It's a tool that should be used with Ausha. and a clear understanding of the potential downsides.
- Speaker #1
I couldn't agree more. It's essential to have a solid risk management plan in place before even considering using leverage.
- Speaker #0
So, as always, we encourage our listeners to do their own thorough research before implementing any new strategy. Don't just take our word for it. Dig into the paper, explore the concepts, and make sure it aligns with your investment goals and risk tolerance.
- Speaker #1
Absolutely. Informed investors are empowered investors.
- Speaker #0
Well said. And on that note, I think it's time to wrap up this deep dive into the world of CTA ETF proxy strategies.
- Speaker #1
I've enjoyed this conversation. It's always fascinating to explore new research and share insights with our listeners.
- Speaker #0
Me too. And for our listeners who want to delve even deeper into the details, we highly recommend checking out the full research paper by Vojko and Poslijova. We'll include a link in the show notes.
- Speaker #1
And as always, if you have any questions or comments, feel free to reach out to us on our website or social media channels. Love hearing from our listeners and engaging in thought-provoking discussions.
- Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktest.com. Happy trading.
