Taken from http://processdriventrading.wordpress.com/page/2/
Picking up from where I left off on my previous post on this topic, I have completed the backtesting of the Andy Lo strategy on survivorship-bias-free data collected right from the most direct source possible. I will let the results speak for themselves:
We see a Sharpe Ratio of ~7. This is pretty good, but the big jump 3 weeks in to 2011 leads us to suspect that there may be some kind of big reversal at some future point. Since survivorship-free data does not exist before 2011, we are forced to wait to collect this information.
What is interesting is that Khandani and Lo predict this strategy will do much better for illiquid stocks. Here is the same strategy on the 100+ stocks on Catalist:
Observe not only is the equity line smoother, but the average return to this strategy is also more than twice that of the one on the Mainboard. Annualizing these returns would indicate that one could get a market-neutral >90% profit every year, unleveraged. The annual risk (stdev) from this strategy would only be ~5%, so the return would be much higher if this strategy was scaled up to the same risk as the market.
Ok.. so what?
This is plainly ridiculous and if it sounds too good to be true, it probably is, but for a very legitimate reason – the difficulty of shorting. The strategy involves going short stocks that outperformed the simple market average and vice versa in order to maintain its market neutrality.
However we can also simulate a long-only version of this strategy by setting all negative weights to zero. This is what we get:
Sharpe actually improves for the Mainboard stocks, and declines but remains at an acceptable 13.4 on the Catalist. Notice also that cumulative profits are approximately halved, allowing the correct inference that the profits from this strategy are equally strong on both the long and short legs.
The money is there, if you want it enough.
Picking up from where I left off on my previous post on this topic, I have completed the backtesting of the Andy Lo strategy on survivorship-bias-free data collected right from the most direct source possible. I will let the results speak for themselves:
We see a Sharpe Ratio of ~7. This is pretty good, but the big jump 3 weeks in to 2011 leads us to suspect that there may be some kind of big reversal at some future point. Since survivorship-free data does not exist before 2011, we are forced to wait to collect this information.
What is interesting is that Khandani and Lo predict this strategy will do much better for illiquid stocks. Here is the same strategy on the 100+ stocks on Catalist:
Observe not only is the equity line smoother, but the average return to this strategy is also more than twice that of the one on the Mainboard. Annualizing these returns would indicate that one could get a market-neutral >90% profit every year, unleveraged. The annual risk (stdev) from this strategy would only be ~5%, so the return would be much higher if this strategy was scaled up to the same risk as the market.Ok.. so what?
This is plainly ridiculous and if it sounds too good to be true, it probably is, but for a very legitimate reason – the difficulty of shorting. The strategy involves going short stocks that outperformed the simple market average and vice versa in order to maintain its market neutrality.
However we can also simulate a long-only version of this strategy by setting all negative weights to zero. This is what we get:
Sharpe actually improves for the Mainboard stocks, and declines but remains at an acceptable 13.4 on the Catalist. Notice also that cumulative profits are approximately halved, allowing the correct inference that the profits from this strategy are equally strong on both the long and short legs.
The money is there, if you want it enough.
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