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  • Leapday Quantitative Research Team

Targeting the most predictive REACTION signals to boost returns in a market-neutral portfolio


Summary


In this report we investigate using a lower starting capital ($10 million for each of the three REACTION signal entry points; $30M in total) compared to previous reports (which used $50 million per entry point; $150M in total) to showcase a market-neutral portfolio. This portfolio is suited for investors with less capital to deploy. Alternatively, this level of starting capital is beneficial for investors who wish to allocate a larger relative proportion of their portfolio to less liquid stocks that tend to achieve higher nominal returns. With this construction we find that annual returns on constant capital are 27.3% with a Sharpe ratio of 2.92 compared to 13.7% and a Sharpe ratio of 2.63 when using the $50 million per entry point portfolio. All results are inclusive of conservative cost assumptions. The increase in portfolio performance results from the ability to concentrate a larger relative dollar amount into positions that have higher nominal returns after taking into account the limitations to individual position sizes due to liquidity constraints.



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Introduction


In previous reports, we constructed market-neutral portfolios which used a constant trading capital of $50 million per REACTION entry point (t0 open + 60min, t0 close, t1 open). A portfolio that traded all 3 entry points would use a constant capital of $150 million. In the portfolio construction, we constrain the trading size per position. For example, we cap the position size according to the max percent of a company’s trailing 20-day trade value. As a result the portfolio’s returns are primarily driven by high liquidity names. The purpose of those reports was to showcase the robustness of the Leapday signals across the range of stock liquidities and convey the high capacity potential of the signals.


In this report, we lower the trading capital to $10M million per entry point and construct a combined portfolio that trades all 3 entry points ($30M million total trading capital). The purpose of this report is to show the performance of a portfolio whose returns are driven to a greater extent by less active companies. This construction will appeal to investors with less capital to deploy and/or investors seeking higher returns on capital (such as smaller hedge funds and proprietary trading firms). 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 for each of the three entry points (t0 open + 60 min, t0 close, t1 open). We then construct a combined portfolio that trades all 3 entry points. Below are all the assumptions used in our portfolio construction including any differences from previous reports.


  • Starting capital of $10M per entry point ($30M for the combined portfolio using all 3 entry points) assuming constant capital throughout the portfolio (i.e., we do not reinvest profits). This change is the most significant difference between this report and previous reports which constructed portfolios that used a starting capital of $50M per entry point ($150M for the combined portfolio).

  • 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).

    • t1 open signal: Enter a trade at the open on the second day the market is open subsequent to a company’s earnings announcement (t1 open) 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 2 percent of a company’s historical average trade value per position for the t0 close and t1 open signals. Trade no more than 1.5 percent for the t0 open + 60 min signal. (The historical average trade value is calculated using the trailing 20 day average traded value.)

  • We cap maximum portfolio leverage at 5x starting capital (i.e. - $50M per entry point). This constraint is used so that the portfolio leverage required to implement the portfolio remains realistic. It was not used in previous reports since the maximum leverage never exceeded 5x. However, the lower capital base used in this report causes the utilized capital to increase thus requiring us to use this constraint.

  • Beyond the three constraints on trade size stated above, trade equal weight.

  • We apply the market direction filter used in our previous report.

  • Round-trip trading costs are based on breakpoints for liquidity group as follows:

    • Low (<$3M historical average trade value): 20 bps (40 bps for t0 open + 60 min signals)

    • Mid ($3M-$25M historical average trade value): 10 bps (20 bps for t0 open + 60 min signals)

    • High (>$25M historical average trade value): 5 bps (10 bps for t0 open + 60 min signals)

    • 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



Results


Below we present performance from 2016 to 2021 H1 for a combined portfolio that trades all 3 entry points of Leapday signals using the assumptions above with a starting capital of $30M.



Metrics associated with the chart above are presented below in Tables 1 - 3.



Similar to our previous reports that used a higher starting capital, one additional caveat to note is that the majority of events take place during a few weeks toward the middle of each quarter. Therefore, a portfolio trading these signals will be in mostly cash during the beginning and end of each quarter. Table 4 below shows that the median day uses 41% of the constant 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.



The portfolio we constructed in a prior report that traded all 3 entry points of the REACTION signals with a starting capital of $50M per entry point ($150M total) and applied the market direction filter discovered in our research had an average annual return of 13.7% with a Sharpe ratio of 2.63. When we reduce this same portfolio to a starting capital of $10M per entry point, performance improves to an average annual return of 27.3% per year with a Sharpe ratio of 2.92.



Discussion


Our research has indicated that REACTION returns are larger for smaller, less liquid companies since they have a more inefficient price discovery process than larger, more liquid companies. This observation would come as no surprise to any quantitative investor. It presents an opportunity for improved returns for investors deploying less capital. The relative proportion of the portfolio that is allocated to less liquid companies is relatively higher with this portfolio construction.


It is understandable that higher AUM firms require strategies that allow them to deploy significant capital for the returns to make a meaningful impact for the firm, and we have shown in previous reports that the REACTION signals deliver this impact in a portfolio composed of predominantly high liquidity names. However, funds with smaller AUM and proprietary trading groups with extra margin available for trading are able to take advantage of the higher returns and higher Sharpe ratios of a portfolio that includes relatively larger positions in smaller, less liquid companies. In addition, as an event-driven strategy that is uncorrelated to the broader market and likely uncorrelated to other trading strategies, the REACTION signals are a strong addition to a firm’s existing portfolio of strategies.



Conclusion


In this report we constructed a market-neutral portfolio which used a constant trading capital of $10 million per Leapday REACTION entry point (t0 open + 60min, t0 close, t1 open). The purpose of this construction was to showcase the versatility of these signals by deploying them with a relatively smaller starting capital than we have previously shown. By using lower initial capital we were able to allocate relatively more notional value into trades for less liquid companies. Because these trades tend to produce relatively higher returns we were able to boost the average annual return on constant capital to 27.3% and the Sharpe ratio to 2.92 with this portfolio compared to an average annual return of 13.7% and a Sharpe ratio of 2.63 in our previous research which used $50 million starting capital per entry point.



 


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.


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