Demystifying

Trading Strategy Returns

Inthispaper,wellexamineaclaimbyaportfoliomanager(letscallhimtraderB)abouthisabilityto generateastatisticallysignificantalpha1.TraderBagreedtosharehismonthlyrealizednet2returns historybetweenMay2003andSept2010forustoanalyze. First,welllookatthetimeseriesgeneralstatisticalproperties,probabilitydistribution,QQPlotand performvariousstatisticalteststoanswersomekeyquestions.

Next,wellcomputetheexcessreturnstimeseries.Forriskfreereturns,wellusethe4weeksTBillasa proxy,andrerunthesameanalysiswedidwithrawreturns. Thenwelllookcloserforevidenceofanyoutliersthatmaybiasouranalysis,whichwillhelpusidentify onepotentialoutlieronApril2009.Toassesstheoutlierimpactonouranalysis,wereplaceitsvalue withaplugvalueandnotethechangeondifferentstats. Finally,wellestablishasimplebandtoidentifypotentialoutliersthatmayaffectouranalysis,andfind oneobservationwithanexceptionallyhighreturn. Insum,thesingleoutlierobservationsinglehandedgeneratesfavorableresults,andthereturnstime seriesdoesnotlookimpressive(tosaytheleast)withoutit.Thequestionweoughttoaskis,howlikely isitthattheoutlierobservationwillberepeatedinthefuture?

Analysis
Forsampledata,weareusinganactivemanagerportfoliosmonthlyreturnsbetweenMay2003and September2010.
25% 20% 15% 10% 5% 0% 5% 10% 15%
Nov03 Nov04 Nov05 Nov06 Nov07 Nov08 Nov09 Feb04 Feb05 Feb06 Feb07 Feb08 Feb09 May03 May04 May05 May06 May07 May08 May09 Feb10 May10 Aug03 Aug04 Aug05 Aug06 Aug07 Aug08 Aug09 Aug10

%Returns

Letsrunthesummarystatisticsoftherawmonthlyreturns:
Alphaisariskadjustedmeasureofthesocalledactivereturnonaninvestment.Itisthereturninexcessofthe compensationfortheriskborne,andthuscommonlyusedtoassessactivemanagers'performances. 2 Thebrokeragefeesandothertradingexpensesarealreadyaccountedforinthereturns.
1

DemystifyingTradingStrategyReturns

SpiderFinancialCorp,2012

Themonthlyreturnshaveasignificantmean(i.e.nozero)andnosignofserialcorrelationorARCH effect.Thevolatilityofthestrategy(5.48%permonth)issimilartothatoftheS&P500index,sothe timeseriesatfirstsightindicatesthatitmayhaveanalpha(akariskfreereturns). LetsplotthedistributionandQQPlotofthosereturns:

4.0

3.0

45%
2.0

40%
Normal

35% 30% 25% 20% 15% 10% 5% 0% 9% 5% 1% 3% 7% 11% 15% 19%

1.0

0.0

1.0

2.0

3.0 3.0 2.0 1.0 0.0 EDF 1.0 2.0 3.0 4.0

ThemonthlyreturnsseemtofollowaGaussiandistributionforthemostpart,butthereisasignofafat tailontherightside.Thisisnotnecessarilybad,sinceitfallsontheupside. Nowletsredirectourfocusontheexcessreturns: Where:

ra r rf

ra istheadjustedorexcessreturn
rf istheriskfreereturn
r istheportfoliorawreturn

Forriskfreereturns,wellusethe4WeekUSTreasurybill(TBill)bondequivalentyield(BEY). DemystifyingTradingStrategyReturns 2 SpiderFinancialCorp,2012


6% 5% 4% 3% 2% 1% 0%
Nov03 Nov04 Nov05 Nov06 Nov07 Nov08 Nov09 Feb04 Feb05 Feb06 Feb07 Feb08 Feb09 May03 May04 May05 May06 May07 May08 May09 Feb10 May10 Aug03 Aug04 Aug05 Aug06 Aug07 Aug08 Aug09 Aug10

%Discount TBill

TheTBillsareissuedonaweeklyschedule,soweinterpolatethevaluestoalignthedatewiththestart oftheholdingperiod.Tocomputethebondequivalentyield( rBEY )ofthe4weekTBillusingthe discountrate( rd ):

rBEY

rd 365 360 rd 28

f Furthermore,tocomputetheequivalentriskfreereturnforagivenholdingperiod( rt (t) d ):

Where:

f rt (t) d rBEY

rd 365 rd d d d 365 360 rd 28 365 360 rd 28

d isthenumberofdaysinagivenholdingperiod

Nowletsplottheexcessortheadjustedreturnsalongwiththeoriginalreturns.Thedifferenceis relativelysmall,andwecanvisuallydistinguishthetworeturnsapart.
25.0% 20.0% 15.0% 10.0% 5.0% 0.0% 5.0% 10.0% 15.0% AdjReturns OrigReturns

Nov03

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May04

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DemystifyingTradingStrategyReturns

SpiderFinancialCorp,2012

Letsexaminethegeneralstatisticalpropertiesoftheadjustedreturns.

Thedescriptivestatisticsareverysimilartotheoriginaldata,withoneexception:thepopulationmean isnotsignificantlydifferentfromzeronoalpha.Interesting! Wecouldstoptheanalysishere,andrefutethepresenceofasignificantalphawhichsymbolizesthe portfoliomanagersskillortalent,butletscontinueanddigdeeper.

40% 35% 30% 4 3 2

Normal

25% 20% 15% 10% 5% 0% 9.2% 5.2% 1.1% 3.0% 7.0% 11.1% 15.2% 19.3%

1 0 1 2 3 3 2 1 0 EDF 1 2 3 4

ThehistogramandQQPlotlookverysimilartothoseoftheoriginalreturns,withsignsofafattailon therightsideofthedistribution.ThereisnosignofanARCHeffect,sowhatiscausingthisfattail? Next,wewillconstructabandorcontourusingtheinterquartilerangeinanefforttoidentifypotential outliers.Oncedetected,welltrytoexplainthemfirst,andthenassesstheirimpactonourfindings. TheInterQuartilebandisdescribedasfollows:

ULt Q3to t 1.5 IQR to t LLt Q1to t 1.5 IQR to t

Inessence,wearecomputingthequartilesandinterquartilerangeusingtheobservationvalues realizedtothatmoment.

DemystifyingTradingStrategyReturns

SpiderFinancialCorp,2012


25% 20% 15% 10% 5% 0% 5% 10% 15% 20%

Inthegraphabove,afewobservationscanpiercethroughtheband,butonlyoneobservationstands out:OnApril2009,thestrategygenerateda21.3%returns.Thisisgood,right? Whetherthevalueisgoodornotisnotthepointhere;weonlycareabouttheconsistencywithother observationsinthesampledata.Letsassessthevaluesimpactonouranalysis:replacethereturns valueforApril2009withaplugvaluesay8%(priormonthreturnvalue)andrerunthesummary statistics.

40% 35% 30%

Normal
3

25% 20% 15% 10% 5% 0% 9.3% 5.2% 1.2% 2.8% 6.8% 10.8%

3 3 2 1 0 EDF 1 2 3

DemystifyingTradingStrategyReturns

SpiderFinancialCorp,2012

 ThedescriptivestatisticstableshowsaGaussianwhitenoisedistribution.Theadjustedreturnsmeanis notstatisticallydifferentfromzeroanditsvolatilityis~17.7%perAnnum.ThisisverysimilartotheS&P 500.

Conclusion
Inouranalysis,theoriginalstrategyreturnsexhibitedastatisticallysignificantmean.Someanalystsmay confusethisparameterwiththestrategysalpha,buttheyarenotthesame.Thealphacanbeonly computedwithexcessreturns(returnsbeyondtheriskfreeinvestment,suchasTBill). Analyzingtheexcessreturnsofthestrategy,themeanisnolongersignificantlydifferentfromzero,but thereturnsdistributionexhibitsafattailontherightside.Diggingdeeper,wefoundthatthisisdue primarilytooneoutliervalue. Insum,basedontheprovideddata,theemployedstrategydoesnotyieldastatisticallysignificantalpha. WhataboutthereturnsonApril2009;shouldwedismissthose?Itdepends,butweoughttoaska differentquestion:howlikelyisthereturnwesawinApril2009toreoccurinthefuture?Ifitisaone timeincident,Idsuggestdroppingitfromthesampledataandapplyingaplugvalueinitsplace.

DemystifyingTradingStrategyReturns

SpiderFinancialCorp,2012