Thursday, October 25, 2012

A leveraged ETFs strategy

In a post some years ago, I argued that leveraged ETF (especially the triple leveraged ones) are unsuitable for long-term holdings. Today, I want to present research that suggests leveraged ETF can be very suitable for short-term trading.

The research in question was just published by Prof. Pauline Shum and her collaborators at York University. Here is the simplest version of the strategy: if a stock market index has experienced a return >= 2% since the previous day's close up to the current time at 2:15pm ET, then buy this index (via its futures, ETFs, or stock components) right away, and exit at the close with a market-on-close order. Vice versa if the return is <= -2%. The annualized average return from June 2006 to July 2011 was found to be higher than 100%.

Now this strategy is actually quite well-known among institutional traders, although this is the first time I see the backtest results published. The reason why it works is also quite well-known: it has to do with the fact that every leveraged ETF need to rebalance at the market close in order to keep its leverage constant (at x2 or x3, depending on the fund). If the market index goes up, the fund needs to buy the component stocks; otherwise, it needs to sell stocks. If there is major market movement (with absolute return >= 2%) since the previous close, then the amount of stocks that need to be bought or sold will be correspondingly larger, resulting in momentum in all those stocks near the close. This strategy aims to front-run this rebalancing to take advantage of the anticipated momentum.

It has been estimated that if the market moves by 1%, the rebalancing could account for up to 16.8% of the market-on-close volume, so the induced momentum can be substantial. Now who is paying for this profits for those momentum traders? Why, the buy-and-hold investors, of course. This loss for the ETFs shows up as their tracking errors, resulting in a cost of as much as 5% per annum for the buy-and-hold investors. Yet another reason we should not be one of those investors!

As Prof. Shum pointed out, if you trade this strategy live today, you will likely get a lower return, because of all those momentum traders who drove up the price way before the close. However, there may be an ameliorating factor at work here: this momentum is proportional to the NAVof the ETFs. As their NAV goes up with time (either due to additional subscriptions or positive market returns), the returns of this strategy should also increase.

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Now for some public service announcements:

1) A company called Level 3 Data Corp sells proprietary data indicating buying and selling pressure on stocks. Their internal backtests show that adding these data to some common stock trading strategies essentially double their returns. An explanatory video is available, and I heard they are offering 3-month free trials.

2) The London Systematic Traders (LST) Club has asked me to say a few words about their new initiative to build a London centric collaborative community of traders, developers and researchers.

LST aims to be at the intersection of traders, developers and quants with a strong emphasis community building and on knowledge exchange, providing a trading networks with a very specific focus on systematic, algorithmic (i.e. automated) or quantitative trading.

Membership is free and open to everybody with an interest in the above topics.

http://www.meetup.com/London-Systematic-Traders/

On Friday, Nov 23, I expect to be hosting a Q&A session with members of the LST (see 2 above) at the Apex Hotel in London. All are welcome. Please visit their website for details.

3) I will be conducting my Backtesting and Statistical Arbitrage workshops in London, Nov 19-22, and look forward to seeing some of our readers there!

34 comments:

GekkoQuant said...

Hi,

Interesting post & paper, I've been playing around with a similar idea. There are a fair few "quantitative index" funds available by the big banks where the strategy rules are completely transparent and laid out in the product book.

Essentially the books give you when and what will be traded by the banks however you don't know the capacity / aum. It may be possible to front run those orders ;)

Ernie Chan said...

Hi GekkoQuant,
Very interesting thought ... do you have an example ticker for this type of funds?
Ernie

GekkoQuant said...

https://ecommerce.barcap.com/indices/action/indexDownload?id=-385897bc8117656498aa61c2196331c5&pageId=1

Page 90 on wards, lists some of Barcap's equity indices including some of the rules (if you can find the factsheet for an index it is 100% explicit in what the algo does).

Oddmund Grotte said...

Hi,

Very interesting blogpost. I've been trading this pattern over the last year but to be honest didn't fully understand the dynamics behind it before I came across your blog. Here is my take on it: http://www.quantifiedstrategies.com/how-to-trade-momentum-in-spy-during-the-last-hour/

Ernie Chan said...

Thanks, Gekkoquant.
My only reservation is that these quant ETFs may not have large enough NAV to generate momentum.

Let's hope for their continued success!

Ernie

Ernie Chan said...

Thanks for the link, Oddmund.
Ernie

x777 said...

Hi! I want to start studying algo trading. How I can start from? I have 7 years expirience on futures/forex and stock markets. Thank you!

Ernie Chan said...

x777,
You can read my book Quantitative Trading as a start!
Ernie

x777 said...

Today Start. My english not good, but I try. Thank you for writing it.

Anonymous said...

I think you may have misread the results. It looks like this strategy returned over 100% over the period studied and not per annum.

Ernie Chan said...

@Anon,
I calculated >100% based on Table 13. It stated there that the average daily return for Price-20 strategy is 0.0048, which translates to 121% annualized.

Prof. Shum has read my post, and she didn't raise any objections to my interpretation.

Ernie

Anonymous said...

Previous Anon again,

I don't see how a strategy that has exposure for 2 hours per trade and trades less than 130 times in 5 years can achieve 100% per annum returns. Figure 8 shows the strategy doubling over about five years (although most of the return is concentrated in 2008/2009). 100% overall is very good for a strategy with such little market exposure.

Ernie Chan said...

Anon,
You are right.

I checked with Prof. Shum again, and she said Table 13 is based only on those days when there were trades executed. So indeed the 100% or so is a cumulative return over 5 years.

Thanks for your vigilance!
Ernie

Anonymous said...

Nice returns but as mentioned above, virtually all of the returns occur in 08-09. The cumulative returns look very similar to daily mean reversion strategies where you make money in periods of extreme mkt volatility. It can be nice to have these type of strategies conditonal in your portfolio. I.e. If vol reaches a certain level, you put a positive weight on it.

Hank

Ernie Chan said...

Hank,
Good point - thanks!
Ernie

binary course guide said...

Great insights, Ernie. I've been studying this trend for months now. Your post made it a lot clearer now.

Anonymous said...

The academics will destroy every single edge traders can find for the shake of publishing a paper. What a waste of a mind.

Ernie Chan said...

Anon,
Actually, academics typically only publish strategies that are already well-known among institutional traders. So I would say that is of net benefit to retail traders. Our job as traders is to find variations of these strategies that are still profitable.
Ernie

Sam said...

I know this post is kind of out of place but I thought one of you guys could help me with ur suggestions. I'm looking for a source where i could pull market data & historical data for Stocks, Futures, options along with dividend data for stocks.
I'm looking for the cheapest ways and am fine with delayed data up to a few mins when it comes to real time.

Ernie Chan said...

Sam,
Earnings.com offer dividend data. csidata.com and Kibot.com offers reasonably priced split/dividend-adjusted historical data.
Your broker should provide you with real-time or slightly delayed data at very low cost.
Ernie

Unknown said...

hi:
thanks for the post and high quality website. Sorry if I missed something obvious, but is one supposed to buy the non-leveraged index when it moves 2% or the leveraged one [I assume when the unleveraged index moves 2%]?
thanks,

Ernie Chan said...

@Unknown:
Yes, the 2% is the move for the unlevered index.

It shouldn't matter whether you buy the unlevered (SPY?) or the levered product (3x ETF?)

Ernie

Unknown said...

thanks for clarification Ernie.

x777 said...

I have finished reading your book. Thank you for it! Which book you advise to read next to develop?

Ernie Chan said...

Hi x777,
You can read any of Larry Connors' books on my Recommended List.
Ernie

Anonymous said...

Hi Ernie,

I am backtesting a delta-hedged option strategy but a bit worried about transaction costs. I trade via IB. Do you have any experience of costs related to frequent delta hedging, at least daily? I am considering trading the 100 most liquid names.

Mike

Ernie Chan said...

Hi Mike,
I have limited experience trading stock options on IB.
Would you be able to use limit orders? If not, you will have to observe the average bid-ask spreads of those options.
Ernie

David said...

I find quant trading forums or discussion groups interesting.

First of all, if you have a successful quant strategy, the last thing you ought to do is share it because if it's good and a lot of people trade it, you could eventually destroy it and make it no longer profitable.

Second, I don't doubt that some of these forums are used to lead people astray. Again, like a magician, you don't share your secret, otherwise, you're no longer mystifying and unique.

My strategies have outperformed the S&P 500 for over five years now and require little to no optimization or maintenance. And by all means they are kept secret.

Ernie Chan said...

David,
The base strategies this and other trading forums discuss are well-known to both professional traders and academic researchers alike. The truly creative and proprietary part is the details of implementation and the variations of the basic scheme.

Since the strategies are open to everyone to backtest and verify for themselves, I don't exactly know how one can be "led astray".
Ernie

Anonymous said...

David,

Outperforming S&P500 over the last 5 years isnt that great.

Whilst this blog has served to spark more creative discussions on strategies that are used by institutional investors, your comments has no accretive value at all.

Good on you that your model needs to optimisation or tweaking. because
1) either you are a fool who believes in his model totally
2) too dumb to make it better

Anonymous said...

Hi Ernie,

I have been reading about the different ways a trader could manage other people money and I am rather confused from the different options. I understand there are many different terms and names including family fund, hedge fund, investment fund, etc, and each has its own commission and fees structure (4% of investment + 20% of gains, only 4% of investment, etc). I was wondering if you could illustrate a bit about the differences and advantages of each.

Thanks.

Ernie Chan said...

Hi Anon,
The typical fee structure is 2% of NAV + 20% of profits.

However, if you have a stellar performance, you can negotiate a higher fee.
Ernie

Clive said...

...leveraged ETF (especially the triple leveraged ones) are unsuitable for long-term holdings...

Provided you're prepared to review/rebalance once per year or so leveraged ETF's are fine for longer term holdings.

Go to etfreplay.com and enter 50% in SSO, 50% TIP and compare that to 100% SPY for any single year (2007 onwards) and you'll see relatively low tracking error.

Ernie Chan said...

Clive,
Besides tracking error, we are also concerned with the fact that 3x leverage is higher than the Kelly optimal.
Ernie