Summary
In this report we construct market-neutral portfolios that restrict trading to only the most liquid stocks. A portfolio that trades both the t0 open + 60 minute and t0 close REACTION signals with constant capital of $50M per entry point ($100M total) between 2016 - 2021Q3 and restricts trades to only the top 500 liquid companies has an annual return on constant capital of 7.8% with a Sharpe ratio of 1.58 and correlation to SPY of 0.07. Expanding trading to the top 1,000 liquid companies results in an average annual return of 10.4% with a Sharpe ratio of 1.88 and correlation to SPY of 0.06. All results are inclusive of conservative cost assumptions. Performance of the most liquid companies is boosted further by applying the market direction filter from previous research with the top 500 liquid companies returning 8.6% per year with a Sharpe ratio of 1.93 and the top 1,000 liquid companies returning 11.2% per year with a Sharpe ratio of 2.21. Trading the top 500 liquid companies uses 14% of constant trading capital on the median day and trading the top 1,000 liquid companies uses 19% of capital on the median day, indicating that this performance is achieved by using very little capital. These results demonstrate the strong performance of REACTION signals among the most liquid companies and establish the high capacity of the signals.
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Introduction
Our previous reports constructed market-neutral portfolios that traded the full coverage of US equities (over 3,000 companies). In these reports we used a constant trading capital of $50 million per REACTION entry point. When constructing the portfolios in these reports we used several position-level constraints on trading size. One of these constraints capped position sizes to a maximum percent of a company’s trailing 20-day trade value. As a result of this constraint, smaller companies had much less impact on the P&L when using $50 million of constant capital per entry point and the portfolio’s returns were primarily driven by high liquidity names.
Institutional investment managers are often constrained to invest in only a subset of the largest, most liquid companies. For these managers, investing in stocks at the low end of the liquidity spectrum is not an option because they are deploying large amounts of capital that require high capacity. To address the concerns of managers with this type of constraint, in this report we construct portfolios that only trade the most liquid companies. This construction appeals to investors with constraints on their ability to invest in less liquid companies. We proceed by reviewing the assumptions used in this portfolio, presenting the results, and discussing the findings.
Portfolio Construction
Similar to our previous reports, we use the strongest one-third of the 3d REACTION signals to construct market neutral portfolios. We will trade both the t0 open + 60 min and t0 close signals and construct a combined portfolio that trades both entry points. Previous reports that built combined portfolios used 3 entry points: t0 open + 60 min, t0 close, and t1 open signals. The t0 close and t1 open signals are fairly correlated as shown in the t1 open report. Therefore, we will only use 2 entry points for the combined portfolio so that the results are not tilted toward the performance of the t0 close / t1 open signals.
Since the primary purpose of this report is to show performance for the highest liquidity names, we establish 2 groups for defining the most liquid companies. The 2 groups are:
Top 500 liquid companies: We limit trades to only companies whose trailing 20-day trade value is among the top 500 companies ranked by trade value.
Top 1,000 liquid companies: We limit trades to only companies whose trailing 20-day trade value is among the top 1,000 companies ranked by trade value.
Below are all the additional assumptions used in our portfolio construction, which are identical to the t0 open + 60min and t0 close reports referenced above.
Starting capital of $50M per entry point ($100M for the combined portfolio) and assuming constant capital throughout the portfolio (i.e., we do not reinvest profits).
Enter and exit trades as follows:
t0 open + 60min signal: Enter a trade 60 minutes after the open on the first day the market is open subsequent to a company’s earnings announcement (t0 open + 60 minutes) and exit the trade on the close 3 days later (t2 close).
t0 close signal: Enter a trade at the market close on the first day the market is open subsequent to a company’s earnings announcement (t0 close) and exit the trade on the close 3 days later (t3 close).
Create a market-neutral portfolio by hedging trades using an opposite side trade in SPY with a beta-adjusted notional value that offsets the beta risk of the event trade.
Portfolio leverage used during periods of high activity.
Trade no more than 6 percent of the starting capital per position.
Trade no more than 1.5 percent of a company’s historical average trade value per position for the t0 open + 60 min signal. Trade no more than 2 percent of a company’s historical average trade value per position for the t0 close signal. (The historical average trade value is calculated using the trailing 20 day average traded value.)
Beyond the two constraints on trade size stated above, trade equal weight.
Construct portfolios with and without the market direction filter used in our previous report.
Round-trip trading costs are as follows:
10 bps for t0 open + 60 min signals; 5 bps for t0 close signals. (Note that we do not use liquidity breakpoints for trading costs in this report as we did in prior reports since all signals are for what we previously defined as the “high liquidity group.”)
Costs are allocated half on entry and half on exit
In the metrics presented below, we assume $0 in hedge costs (for the SPY hedge) and the hedge does not use any equity or margin
Table 1 below shows the number of trades these settings correspond to between 2016-2021Q3 when trading both the top 500 liquid companies and top 1,000 liquid companies. We show the number of trades with and without the market direction filter applied.
The number of trades shown above is less than one would expect using one-third of total signals. With 500 stocks, one would expect 167 trades a quarter or 668 trades a year. However, we only report 546 trades per year on average for the t0 open + 60min signal and 423 trades per year for the t0 close signal. The reason that we see fewer trades here is because the REACTION signal magnitude is negatively correlated to stock liquidity. Therefore, fewer highly liquid companies show up as extreme signals relative to what we would see if the signal had no liquidity bias.
Results
Below we present performance from 2016 to 2021 Q3 for a combined portfolio that trades the t0 open + 60min and t0 close signals using the assumptions above with a starting capital of $100M and only trades the top 500 and top 1,000 most liquid companies. We begin with portfolios that do not apply the market direction filter.
Metrics associated with the chart above are presented below in Tables 3 - 5.
A majority of earnings events take place during a few weeks toward the middle of each quarter. Table 6 below shows that when only trading the most liquid companies, the median day uses 14% of the constant capital for the top 500 liquid companies and 19% of the constant capital for the top 1,000 liquid companies indicating that the performance above is achieved by using very little capital. Thus, returns presented above are conservative for a portfolio setting since an investor would have significant capital to deploy into additional strategies during much of the year. Return on capital used is significantly higher than reported above.
We also present performance from 2016 to 2021 Q3 for the same combined portfolio above, but applying the market direction filter from previous research.
Metrics associated with the chart above are presented below in Tables 7 - 10.
Like our previous research with the market direction filter, performance of a portfolio that only trades the most liquid companies is also boosted by applying the filter. Average annual returns are higher when using the market direction filter with higher Sharpe ratios and smaller drawdowns.
Discussion
Institutional investment managers are oftentimes constrained with respect to their investable universe due to their AUM. Accordingly, they need to evaluate signals under assumptions that are realistic for their implementation. These assumptions include constraining the universe of investable companies to only the most liquid stocks. By applying such a constraint they can be more confident that backtested results are realistic and scalable with the size of their portfolio. This report shows that the REACTION signals perform strongly when constructing a portfolio of only the most 500 or 1,000 liquid companies.
Conclusion
In this report we constructed market-neutral portfolios that restrict trading to only top 500 and top 1,000 most liquid. The purpose of this construction was to showcase the value of the REACTION signals for investors who invest in the largest, most liquid companies and for investors who are deploying large amounts of capital that require high capacity.
A portfolio that trades both the t0 open + 60 minute and t0 close signals with constant capital of $50M per entry point ($100M total) between 2016 - 2021Q3 and restricts trades to only the top 500 liquid companies has annual returns on constant capital of 7.8% with a Sharpe ratio of 1.58 and correlation to SPY of 0.07. Expanding trading to the top 1,000 liquid companies results in annual returns of 10.4% with a Sharpe ratio of 1.88 and correlation to SPY of 0.06. All results are inclusive of conservative cost assumptions. Performance of the most liquid companies is boosted further by applying the market direction filter from previous research with the top 500 liquid companies returning 8.6% per year with a Sharpe ratio of 1.93 and the top 1,000 liquid companies returning 11.2% per year with a Sharpe ratio of 2.21.
Trading the top 500 liquid companies uses 14% of constant trading capital on the median day and trading the top 1,000 liquid companies uses 19% of capital on the median day, indicating that this performance is achieved by using very little capital. These results demonstrate the strong performance of REACTION signals among the most liquid companies and establish the high capacity of the signals.
Disclaimer
This material is solely for informational purposes and is not an offer or solicitation for the purchase or sale of any security, nor is it to be construed as legal or tax advice. References to securities and strategies are for illustrative purposes only and do not constitute buy or sell recommendations. The information in this report should not be used as the basis for any investment decisions. We make no representation or warranty as to the accuracy or completeness of the information contained in this report, including third-party data sources. The views expressed are as of the publication date and subject to change at any time. Hypothetical performance has many significant limitations and no representation is being made that such performance is achievable in the future. Past performance is no guarantee of future performance.