The Secret World of Algorithmic Trading

In recent times I have been doing a fair amount of algorithmic trading based on a system that I designed a few years ago (which I rather unimaginatively named “Black Box”).

Black Box is just a piece of software that uses statistics to determine long and short entry points for a group of large highly liquid stocks. Each trade will typically result in a profit of between 1.5% to 4% (over an average holding period of 14 days - an annualized return of 39% to 104%). All trades are given up to 39 days to reach their targeted return before being time stopped.

I will normally have 1% to 2% of my portfolio invested in each trade. Black Box bases the trade size on the volatility of the underlying stock combined with the maximum allowable loss.

Black Box is seldom wrong in its signals, but of course it will be wrong on occasions. One of the main features of Black Box is its ability to largely filter out noise in price movements which is the bane of most traders. Of course I’m not going to tell you how Black Box does this, or indeed how Black Box works at all. The only systems you can see for free are the ones that don’t work.

While I still hold a long portfolio of great stocks like Berkshire Hathaway, Coca-Cola Amatil (CCL.AX) and Woolworths (WOW.AX), there are very few companies post GFC that can just be bought and held on to. However, there are far more than can be successfully traded using algorithms.

The primary criteria I use for algorithmic trading candidates are:

1. Large companies;
2. Highly liquid;
3. Fundamentally sound;
4. Relatively high price volatility.

Once I’ve selected the companies, it’s then a matter of feeding the required data into the computer which uses my algorithms to spit out entry signals on both the long and short sides. Ex dividend dates and important announcements also come into play here.

It’s always exciting to see what signals the computer is going to give. Of course, sometimes it won’t give any signals at all, which is fine.

Algorithmic trading is not for everyone, it requires a good knowledge of the relevant mathematics and statistics (that’s why all those huge algorithmic hedge funds employ mathematicians, in fact mathematicians like Ed Thorpe and Jim Simons were pioneers in this industry). But all this doesn’t mean that you have to be a mathematical genius. Algorithms vary in their complexity and complexity doesn’t automatically equate to larger profits.

It’s not much use buying books on the subject of algorithmic trading. As always, no one is going to give you the algorithms and strategies that will make your fortune in a book! Successful strategies and algorithms are normally being used by a few enough people to be effective. Once a strategy is widely known it will cease to work and that is the basic problem with any valid strategy that has been published in a book (or for that matter on the internet).

I may publish some of Black Box’s past trades here in coming months, so stay tuned.

Happy New Year to all.

The Platinum Asset Management Trusts Muddle Along

I have for a long time been an admirer of Kerr Neilson, the founder of Platinum Asset Management. But in recent times I have begun to wonder whether Neilson was just fortunate to have obtained some very large returns fairly early on in the history of Platinum that has made the overall record of his funds look much better than what more recent investors have actually experienced.

It may be interpreted as some sort of signal that up to the 31 December 2009 Platinum Trust Quarterly Report, there were colour pictures of each portfolio manager smiling, then in the 31 March 2010 Report they changed to black and white pictures of each portfolio manager looking much more austere. Why? Was Neilson concerned that they looked too happy given the actual performance of the funds? Yes, I do think that’s the answer.

The latest Platinum Trust Quarterly Report (available on Platinum’s web site) shows that the International Fund (managed by Neilson and by far the biggest of the Platinum funds), has returned zero percent over the last five years and 12.1% compound since inception (in 1995).

I guess I have two issues with this.

Firstly, does a compound return of 12.1% per annum over 16 years justify Neilson’s estimated 2011 net worth (by Business Review Weekly) of $A2.1 billion?

I would say absolutely not, that sort of return should not be sufficient to propel a fund manager to that level of stupendous wealth. If you can return 20%+ over that time frame, sure, I would grant you billionaire status, but the difference between 12.1% and 20% over that time frame is the difference between turning $1 million into $6.2 million versus $18.5 million.

Secondly, the Platinum funds are able to take short positions (something the vast majority of mutual funds cannot do). Therefore, one would think that Platinum could have positioned itself to be far more market neutral than its performance indicates it has been. If the commentary in various Platinum Trust Quarterly Reports is any indication, Platinum has traditionally performed poorly with its short positions.

The problem it seems to me is that Platinum has tried to pick individual companies to short (with limited success) and has also not maintained a sufficient proportion of its portfolios short in order to make it more market neutral. I would have had a much higher percentage of the portfolios short and I would have done this over certain (European) markets – not individual companies.

The other problem is that Platinum seems to form (not always accurate) macro economic views and then invest accordingly (and I might add somewhat stubbornly, being slow to change a view when circumstances clearly change).

Yet another problem is the division of funds into geographic areas: Asia, Europe, Japan etc. If Europe is in deep trouble and you have a European fund (that only has 6% of the portfolio short), what’s going to happen to the investors money? Answer: Kiss it goodbye! And sure enough, the latest Platinum Trust Quarterly Report shows this fund lost 14% in the last quarter – yes, in one quarter, this is staggering!

The Platinum Trust Quarterly Reports are always written in a very articulate style and always give the impression that the writer knows exactly what he/she is talking about. Complex and uncertain economic situations are discussed with breathtaking simplicity and confidence.

But the actual fund results don’t fully support such confidence. For example, how can the Platinum Asia Fund (a $A3 billion fund) lose a whopping 17.2% over the last year when it has the ability to take short positions and is presumably being managed by people who know what they are doing?

(Incidentally, I have always thought that Kerr Neilson either writes or edits every single one of the various commentaries, the writing style is so similar for each fund, but that just might be me being a bit too cynical).

Absent a significant rally on global markets and Platinum’s continued refusal to take larger short positions, I cannot see how Platinum is going to improve its returns to investors.

Most of Platinum’s investors are Australian and as such have been able to get bank interest rates of anywhere from 5% to 7% over the last five years, so I would say, why pay fees to get zero percent?

The Insanity of Australian House Prices

Traditionally house prices in Australia have equated to approximately five times average weekly ordinary times earnings (AWOTE) as published by the Australian Bureau of Statistics.

Currently house prices are anywhere from six to nine times AWOTE (depending on which city you look at).

The real estate listings in Australia are littered with houses that cost $1 million+ and we are not really talking about prime properties here. Very average houses that happen to be reasonably close to a city centre now command sale prices of $1 million+.

Those who have a vested interest in absurdly high property prices will come out with all sorts of nonsense to justify the prices being paid: limited supply, zoning restrictions, immigration etc.

The truth however (as always) has got to do with interest rates – cheap credit, similar to the cheap credit that was available in many other countries prior to the collapse of their housing markets.

The seeds of the housing bubble (as in the US) were sown after the dot com crash when the Reserve Bank of Australia (RBA) foolishly followed the US Federal Reserve in lowering interest rates to artificially low levels.

The fact that Australia had very few dot com companies, that the Australian share market declined by nowhere near what the US market did in that period and that Australia was not about to have a recession (like the US did) seemed to have been lost on the RBA.

The top officials at the RBA are paid a fortune in comparison to their US counterparts and yet they get it wrong as often as they get it right.

When people can borrow very cheaply, what do you think they are going to do? It’s not a trick question.

They are going to borrow more than they previously could have which then allows them to pay more for housing. There is of course no free lunch – house prices increase in proportion to the availability of credit. As Buffett famously said, when everyone watching a passing parade decides to stand on their tip toes, no one gets a better view.

As the Australian banks source approximately 40% of the funds they lend offshore, there is always the risk that they will at some stage be forced to act independently of the RBA in raising mortgage rates (as they have already done on a few notable occasions).

The RBA and many politicians will protest vehemently about that but it’s precisely their policies that have caused the problem: The RBA for keeping rates at artificially low levels for a prolonged period causing a borrowing binge and successive Australian Governments for discouraging savings through punitive tax policies, while at the same time encouraging speculation in the housing market by allowing ludicrous practices such as “negative gearing”.

This offshore funding dependence is why Moody’s recently downgraded the credit ratings of the big four Australian banks.

There are only two things than can happen to Australian house prices, they can collapse dramatically like they have done in the US, the UK, Ireland and Spain or they can go through a prolonged period (perhaps 10 years) of practically no price appreciation. I would favour the latter, but no one can rule out a price collapse.

What is absolutely clear to me is than anyone buying a house today in Australia (who doesn’t have to buy one) is not investing – they are taking a gamble for which they are more likely than not to pay dearly for down the track.

Yes, it’s not conventional wisdom, I know, but I’ve made a lot of money ignoring conventional wisdom (or what some fool at the Housing Industry Association is telling another fool in the media).

It is somewhat amusing to see people (who understand nothing of financial mathematics) who think that house prices can keep doubling every 7-8 years (as they have done in Australia over the past 7-8 years). This is simply not possible over long periods of time because the point will be reached where practically no one can afford a house – and that won’t happen, prices will correct before that point is reached.

No one can be certain when this party will come to an end and it might very well end with a whimper rather than a bang, but end it will.