CME Outage, Quant Models, and Prices

 

Prices are the lifeblood of any quant model. If you have the wrong input, you will get incorrect predictions. In the case of an outlier, a single incorrect price may generate misleading signals about future opportunities, so any model should be thoroughly reviewed to assess its sensitivity to wayward signals. 

If there are incorrect inputs, the model output should be adjusted to reflect the change in data when a replacement is made. Users have to be alerted to any changes. These are easy cases to deal with. There are also more difficult issues, such as data oddities or anomalies. 

For example, the CME outage during the Thanksgiving period is a market anomaly that has to be addressed, especially given that it occurred at month-end. To provide context, there was an 11-hour system outage ending at 1335 GMT. It was during the Thanksgiving break, which is associated with low trading volume in the US, but it impacted all global markets on a Friday, a month-end. An outage will lead to a change in trading and a surge upon reopening. Hence, the inputs for open, high, low, and close will be distorted from what they would be in the absence of an outage. This will lead to slightly different signals generated from any model. 

So what should a modeler do about this? One response is that the price is the price and to do nothing. It is reasonable and defensible, yet it may seem odd not to account for some distortion; however, there is no way to determine the impact of any outage. What would be the right price? Another option is to drop the price to the last close. This can be defended, but replacing data seems somewhat arbitrary. 

The best response is to focus on the output and look at the marginal trade signals generated. Does it matter? An output sensitivity analysis can be conducted to see what happens with the new prices, rather than looking at what would have happened if no change had been made. If there are small marginal changes, then keep the latest prices. If there is a large set of new signals, investigate further on why and flag the changes. The prices can be kept, but the flagged trades can be ignored. However, this creates another set of problems if the trade is closing an existing position. When do you exit the old position?

These real-life problems tell the user that there is no such thing as a fully automated system.

The 60/40 stock/bond mix can result in periods of no return

 

Still spending time on the 6/40 stock bond mix. The reason is simple - it is the benchmark for asset allocation. Yes, it works; however, investors should be aware that there are extended periods of flat returns. You can have lost decades of no performance. The challenge is finding alternatives during these flat periods, especially when real yields are negative. Can alternative investments do the trick? The core solution is to find positive real returns with low correlation to equities. Trend-following can do it, but the core returns do not match the periods of lost decades. The challenge is finding the right mix at the right time, with clear rules for triggering a switch in asset allocation.

The changing value of diversiification

 

Hail the 60/40 stock/bond portfolio. It has worked, yet a recent AQR research piece, Diversifying and the Rearview Mirror,  suggests that the value of the 60/40 portfolio will change based on the variable Sharpe ratio of the stock-bond combination. There are times when diversification beyond the 60/40 mix is a drag and other times when it is needed. The average Sharpe ratio for the stock/bond mix is 0.4, so if the Sharpe ratio reaches 1 or falls below -0.5, it is likely to mean-revert. Hence, a selective diversification strategy is valuable. If you feel too good about your 60/40 mix and it feels like diversification is a drag, start diversifying, and if you think the 60/40 mix is proving to be wrong, it is likely to work in your favor. In practice, this is not easy to implement, but it is worth thinking through when to diversify.

Narrative sentiment and attention matters - Read the news!

 

In the paper "The Power of Narrative Attention: Linking Geopolitical and Economic Storylines to Currency Risk and Return Predictability", the authors find that narrative shocks are not fully priced into FX markets and will impact returns over a period of weeks. Even after accounting for major factors, fluctuations in currency markets show time-varying exposure to economic narratives such as recessions, trade wars, and inflation. Narrative sentiment can vary depending on the tone and volume of coverage.

Even if you are a quant, you should read the news and stay aware of current market narratives. However, these narratives can be systematically measured and incorporated into a model to increase explanatory power. We always knew this was the case, but the key finding is that narrative sentiment persists and is independent of other factors.

Be situationally aware of what is being reported in the news, which can often be systematized.