Tag: quant

Long-Short Trend Following

Prior Work

We had discussed the SMA On/Off Switch and its ability to escape the worst days. Based on this finding, we setup a Tactical Theme that would go long NIFTYBEES and JUNIORBEES if the CNX 100 index is trading above its 50-day SMA and move into LIQUIDBEES otherwise.

What if, we could go long and short?

Naive Long-Short

Here’s how going long above 50-DMA and short below 50-DMA on the CNX 100 since 2001 compares:

CNX 100.02-Jan-2007.28-Apr-2015.long.short
Long-Short SMA (black), Long-Only SMA (red) and Buy & Hold (green)

It looks like going both long and short is not significantly better than a long-only tactical strategy.

Long-Short with Volatility

But what if, we add a volatility metric into the mix? The logic here is that corrections are preceded by a bout of volatility. So if you go short if either or the volatility signal or the 50-DMA indicates a negative bias and long otherwise:

CNX 100.02-Jan-2007.28-Apr-2015.long.short.volatility
Long-Short SMA w/ Volatility (black), Long-Only SMA w/ Volatility (red), Long-Only SMA (green) and Buy & Hold (blue)

It looks like there is significant alpha in the combination approach.

Long-Short NIFTY and BANKNIFTY

NIFTY returns since 2001:
CNX NIFTY.01-Jan-2001.28-Apr-2015.long.short.volatility

And the same for the BANK NIFTY since 2006:

CNX BANK.12-Jan-2006.28-Apr-2015.long.short.volatility

NIFTY and BANKNIFTY since 2011:

CNX NIFTY.03-Jan-2011.28-Apr-2015.long.short.volatility

CNX BANK.03-Jan-2011.28-Apr-2015.long.short.volatility

NIFTY and BANKNIFTY since 2013:

CNX NIFTY.01-Jan-2013.28-Apr-2015.long.short.volatility

CNX BANK.01-Jan-2013.28-Apr-2015.long.short.volatility
Long-Short Combo (black), Long-Only Combo (red), Long-Only Tactical (green) and Buy & Hold (blue)

Conclusion

It appears that there is long-term alpha in using a combination of volatility and 50-DMA to implement a long-short strategy. To put this to test using real-time data, we have created a theme to make it easy for you to follow along: Trend Long-Short.

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The SMA Risk On/Off Switch

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Market timing is a very divisive topic in investing. For traders, it has been the search for the holy grail. For passive investors, a source of derision.

Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves. – Peter Lynch

Does it mean investors should just remain long all the time? Hardly, according to the latest research by Meb Faber (ssrn).

Data for international markets show that volatility increases in declining markets. Any strategy that keeps you out of those periods, will improve your portfolio returns. The outline of his strategy is simple: go long the market if it is trading more than its 200-day SMA and stay out of the market otherwise.

A small amount of outliers have a massive impact on performance and the best and worst outliers tend to cluster when the market is already declining. However, if you miss the best and worst days in every case your compound return is higher than buy and hold.

It works across most international markets:

miss best and worst days

Unfortunately, the paper doesn’t discuss the Indian markets, so lets try and fix that.

Best and worst days

The table below shows that in a rising market, +1% days (BEST) outnumber -1% days (WORST) and the reverse is true of declining markets. Also, as you decrease the look-back period, the WORST to BEST ratio increases in a declining market.

nifty best worst

Cumulative Returns

If you apply the SMA switch to the Nifty index, here’s how the cumulative returns look like:

nifty cumulative returns

200-day SMA Cumulative Return Chart

Since: 2000
CNX NIFTY-200-day-sma-returns-2000

Since: 2010
CNX NIFTY-200-day-sma-returns-2010

50-day SMA Cumulative Return Chart

Since: 2000
CNX NIFTY-50-day-sma-returns-2000

Since: 2010
CNX NIFTY-50-day-sma-returns-2010

Drawdowns

If the SMA rule really helped investors stay out of negative fat tails, then it should manifest itself in the drawdowns.

drawdowns

Conclusion

Using a simple SMA rule helps investors avoid drawdowns and boost returns as compared to a naive buy and hold strategy. The smaller the look-back period, the better the returns and lower the drawdowns.

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Market Cap Deciles

Introduction

Segmenting the market to track performance, risk etc. has been around for a long time. The Dow Jones Industrial Average was launched in 1896, the Sensex since 1986 and the Nifty since 1995. They provide a short-hand to gauge market performance and track returns over a period of time.

Index construction

An index can be constructed based on any combination of factors that are common to its constituents. They can be sectoral like FMCG, IT, etc. or they can be based on fundamental factors like book value, sales, etc. However, the most common way to construct an index remains free float market capitalization. This is the approach that most indices, like the Nifty, take.

The Nifty lists the following criteria for its constituents (NSE):

  1. Liquidity (Impact Cost)
  2. Float-Adjusted Market Capitalization
  3. Float
  4. Domicile
  5. Eligible Securities
  6. Other Variables

Deciles vs. Indices

Using existing indices come with some disadvantages:

  1. Rebalancing usually occurs once every 6 months – a lot can happen in that time.
  2. They usually have “other” considerations – not entirely quantitative.
  3. Do not cover the entire market – the biggest index in the NSE is CNX 500 that track 500 stocks.

An alternative is to build your own set of indices based on purely quantitative considerations. For example, you could divide the market into deciles based on their free float market cap and set a minimum daily turnover. This will then allow you to track micro-cap through mega-cap performance over arbitrary time frames, track how different stocks transition through deciles, set up “early warning” signals, etc.

Example

If you divide the market into deciles and set the minimum daily turnover to be 0.01% of float, then you end up with about 140 stocks in each. The 1st decile would be the micro-caps while the 10th would be the mega-caps. Here’s how the different deciles performed this week:

decile

Watch out for decile performance charts in our weekly and monthly performance roundups!

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