Thursday 20 November 2014

Head to head: technical and fundamental trading systems

A few years ago I was working at a quant hedge fund with the glorious job title of Head of Fundamental Trading Models. It sounds grand I know, but it was just three of us: me, a mad Canadian guy and a madder Italian guy; occasionally augmented with some poor interns. When we weren't building and managing trading strategies we used to amuse ourselves with turf wars with the Head of Technical Trading Models, and his merry band of rocket scientists.

Fast forward to the present day and I entrust a big chunk of my net worth to a purely technical trading system (the rest is in a bunch of shares and exchange traded funds which I 'manage', or rather idly neglect, on a vaguely discretionary fundamental basis). 

So which is better?

First some context

Systematic trading strategies vary in the source of data they use, using either technical or fundamental information. Strategies which are technical use only prices as an input. Technicians believe that all necessary information is already impounded in the market price, and other inputs are futile. 
Non price, fundamental data, comes in two main flavors. Micro data is about a specific asset, for example the yield of a particular bond or the Price Earnings ratio of a companies stock. Macro data is about entire economies and could include inflation or GDP growth. There are also forecasts available for many kinds of fundamental data.
It's time for the big head to head: Technical vs Fundamental systematic trading systems. Who will be victorious?

Data collection and cleaning



We get a price. Sometimes it might be a bit dodgy, but given an estimate of typical variability of price between collection points, we can set up simple automatic filters that will catch unexpected moves.



We get a price. And a whole bunch of other stuff. Accounting ratios for stocks, interest rates, inflation,... the list goes on. So if I have 10 variables for each instrument I'm trading, then I need to collect 10 times as much data. Right now I spend about two minutes per month checking each of the 50 plus futures contracts I trade, or roughly 5 minutes a day in total (basically when the aforementioned filters are triggered). Do I really want to make that 50 minutes a day? When would I have time to watch TV?

Technical 1. Fundamental 0. First blood to the chartists!

Data bias and manipulation


It's a price. Unlike certain other financial variables, which will remain nameless, traded prices are mostly hard to manipulate or generally muck about with. Well okay, there are some games you can play, but they don't move prices enough to seriously interfere with the signal of a trading system.


Anyone who thinks that accounting data can't be manipulated needs to read The Smartest Guys in the Room, at least twice. Economic data is probably reasonably okay, in least in developed countries. But it can be biased. And there are these lovely indices which try and predict / encompass other fundamental variables, which at some point in the past had their weights fitted with an in sample regression

Technical 2. Fundamental 0. The technical guys are really showing their quality.

Data frequency, lags and revisions


Even if you have no money you can get a price with a 15 minute delay free from at least 8 million websites on the internet. If you're prepared to stump up for a live feed, or you're broker will give you one in exchange for the vast amounts of commission you are paying them, you can get your price within milliseconds. And once you have the price, it isn't going to get changed. And within a fraction of a second of getting it, you can get a new price (well it might not have moved, but in principle you can get a new one).



You want GDP? Sorry you're going to have to wait sir, it's only quarterly. Yes, four times a year, the clues in the name. It's the end of the quarter? You're going to have to wait a few weeks have elapsed. We need to, add a bunch of stuff up, or something. And just when you think you've got it, we're going to change it in 3 months time. Then we'll change it again. And again. And so on for several years. You want to know what the original number was, so you're backtest isn't biased? Sorry we don't have it. Or we'll charge you an arm, a leg, and a kidney for it.
By the way did you know that 10 years ago the publication delay was 3 months, not 3 weeks? You'll have to factor that into your backtest as well. If you can even found that detail out...

Technical 3. Fundamental 0. They're really on the ropes now.


Surprise, Surprise



Is the price now what we expected it to be yesterday? Possibly. Is it what the market expected it to be? What does that even mean (except in the rare case of forward prices being unbiased predictors of future spot price movements...)?



Are non farm payrolls today what we expected yesterday? I can tell you the expectations, mean and distribution, and how they've changed since the last number (though that data isn't free). Same thing for the earnings announcement of Google that's coming out (free on Yahoo finance, et al).

Forecasts are another source of data. Comparing forecasts against reality - surprise - adds yet another dimension we can investigate.

Technical 3. Fundamental 1. It's half time and the technical team are in a strong lead.





The changes in the price of US 10 year bond futures can be easily compared against the same for German 2 year bonds, or live hogs for that matter; and they can also be compared against the price of US 10 year bonds thirty years ago (once you've done some volatility normalisation anyway).



Can we compare US inflation against UK? Not easily. Investment banks hire whole team of economic analysts to understand this kind of stuff. It's hard to write automated software that can deal with this issue. Similarly can you compare the price book ratio of a UK bank, against a German manufacturer, versus a Japanese Retailer? Probably not. What about earnings price ratios now, versus a time when the level of share buybacks was different? Tricky. The only way to deal with this is either to ignore it and live with the consequences, or be careful only to compare like for like (eg UK banks against their peers), which reduces the size of portfolios you can trade.

Technical 4. Fundamental 1. What a cushion. Can the fundamentals pull it back?


Variety of trading strategies



I am constantly surprised by the number of technical trading rules that are out there, and even more amazed by some of the very silly names they have. Especially since nearly all of them are just trying to pick up trends. Something you can do very easily with one or two rules.



It can be shown mathematically that the number of possible strategies is loads bigger if you have more than one variable you can measure.
Number of technical strategies = Number of variables (1) x Human capacity to come up with silly names
Number of fundamental strategies = Number of variables N! x Human capacity to run panel regressions.

Technical 4. Fundamental 2. A consolation price for the losers, or the start of a fightback?


Rich cross section of data



Suppose you've got twenty years of daily price data for instrument X. That means you've got about 5000 data points. Collecting it more frequently will give you more data points, but not much extra information. Pooling data across X, Y and Z will also help. But there's limited change of finding something interesting, that hasn't already been discovered and given a silly name, without full on data mining. 



So with ten variables you've got 50,000 data points for X. Loads more once you've pooled it with Y and Z. That's a very meaty data set. Lots to dig into before running up against the boundary of statistical significance.

Technical 4. Fundamental 3. We're into extra time, and it could be anyone's game!


Fun and knowledge



Oh look its a wavy line. I don't really need to understand why its wavy, just predict the next wave. I can hire any old Phd to analyse it. They don't have to have any knowledge about trading markets, and there is no point in them learning anyway. And after a few years of looking at the wavy line they're going to be bored sick, and go back to something useful like looking for Higgs Bosons and landing stuff on comets.



You want to trade oil futures, with fundamentals? You need to know about peak oil, weather, Saudi Arabian politics, Shale Gas,oil rig maintenance cycles, electric car take up rates, Putin's psychological state and a hundred other things.
Then you need to work out a way of putting that into a fundamental model. You can spend the rest of your life learning how to do this stuff, its fascinating. You'll never get bored.

Technical 4. Fundamental 4.

And there's the final whistle...

It's a draw. And no, there are no penalties. Are you really surprised?
I have worked extensively with both kinds of data and I have no strong preference. Technical systems are easier to build and run, but the additional effort required for including fundamental rules will usually be rewarded with additional profits. 

Unfortunately as I don't have any staff, the additional effort is not something I am willing to put in right now, so I am sticking with my simple technical systems.