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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 35367  
Subject: Trading Bond Funds: a Thought Experiment Date: 1/14/2006 2:59 PM
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Disclaimer: The following is me thinking aloud, not an invitation that anyone do the same. I'm merely sizing up the problem, so as to identify a line of attack.

The experiment, of which this in merely a beginning, is a partial response to a recent paper by Po-Hsuan and Chung-Ming Kuan, “Re-examining the Profitability of Technical Analysis with White's Reality Check and Hansen's SPA Test”. In the paper they find that “…significantly profitable simple rules and investor's strategies do exist in the data from relatively 'young' markets (NASDAQ Composite and Russell 2000) but not for those of more 'mature markets' (DJIA and S&P500)….Compared with the buy-and-hold strategy, it [was] also found that such profitable rules and strategies can generate higher returns even when transaction costs are taken into account.”

Notes: They use the terms “simple rules” and “investor's strategies” in a special, but non-controversial sense, and the inserted emphases are mine.]

I would quibble with some of their methodology and their distinction “young” versus “mature” markets, but with not their overall results. They merely reaffirm what any trader knows and what nearly every academic denies, which is the ability to “beat the market”. What I propose is to apply some of their methodology to a common, fixed-income instrument, bond funds.

(1) DETERMINE A POSSIBLE TRADING UNIVERSE.
I exclude from consideration any derivative (which is what bond funds are) whose underlying can be better traded directly than through a commercially available composite. [That's a judgment call, admittedly, but it's my experiment.] Also I exclude any Open-end Fund for which there exists an equivalent CEF or ETF. [That particular investors might think that their investing world cannot extend beyond the fund choices provided by their 401k plan and such is their self-imposed delusion, with which I have no sympathy.]

(2) HAVE NO BIAS AS TO MARKET SIDE.
Going long is not the mere inverse of going short. The two are NOT symmetrical, though, sometimes, for convenience (and in such things as SAR systems) they are traded as such. Most people will favor one side of the market or the other. But such favorings must be justified for reasons that go deeper than custom or initial comfort. To make a reasoned and tested choice is the only honest choice.

(3) DETERMINE A POSSIBLE SET OF TRADING RULES.
The goal is an explicit set for rules for determining when to create, add to, scale down, or exit from positions (for the sake of capturing profits or minimizing losses) and whose back-testing augers success when traded forward in real time, with real money. The fewer, the more comprehensive, the more non-discretionary the rules, the better.

(4) FUND AN ACCOUNT
$25k is a convenient minimum for meeting the SEC's PDT requirements, but funding will depend upon the need to properly size positions and to properly manage risk, which has this consequence: although a particular trading program is proven viable, it might not be implementable by investors with insufficient assts. (You don't shoot elephants with a 22.)

(5) DETERMINE HOW TO MEASURE EXPERIMENTAL “SUCCESS”
The two common benchmarks for measuring the efficacy of trading systems against Buy-and-Hold/Passive Indexing/and their ilk (or else, why have a trading program?) are “greater profits with equivalent risk” and “equivalent profits with lesser risk”. Conventional academics persistently cause their disbeliefs about the possibility of trading success to become a reality when they attempt to trade either for their own accounts, or act as advisors or directors to mutual funds or hedge funds. And some very immanent, Noble-prize winning ones have achieved especially catastrophic failures, as Lowenstein chronicles in “The Failure of Genius”. (In short, traders despise academics; academics return the favor. So, what's new?)

Therefore, to argue yet again, for or against the fact that trading the underlying directly, in the case of bond funds, rather than merely owning the derivative itself, can provide superior results would be to beat a dead horse. Even in the small sample population of this discussion board, there are too many fixed-income investors whose personal experience and testimony so attests to that fact for their success to be explained away as “outliers” as academics are want to do when confronted by evidence that contradicts their pet theories. (Which was Jack's point in his posts #14936 and 14946).

I would concede that not all sub-classes of bonds can be easily accessed directly, perhaps the most egregious one of which is foreign bonds. But I would never concede, unless I could prove otherwise, that the practical necessities of accessibility imply or obligate a Buy-and-Hold or “passive indexing” strategy. Instead, I would claim that if trading beats B&H/PI elsewhere (in the more obvious cases of the FI fund world), it also beats them in the residual cases as well, which is what I want to focus on, some isolated or residual cases where the construction and marketing of bond funds might have merit or justification but, nonetheless, should be traded rather than held passively.

Furthermore, I'll make this claim. B&H is merely a sub-set of the universe of trading strategies, not a thing apart from them, and its efficacy must be tested for whenever a trading program is proposed. There are plenty of very special instances when B&H becomes a very superior strategy. The mistake that most investors make –-and the lie that the fund industry wishes to propagate—is that those special cases are the norm, rather than an outlier.

This IS the Motley Fool forum, right? where our task is to question to the conventional “wisdoms”.

Charlie
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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14959 of 35367
Subject: Re: Trading Bond Funds: a Thought Experiment Date: 1/14/2006 5:00 PM
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CORRECTION: The first author's name is Po-Hsuan Hsu.

The paper can be found here:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=821759

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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14960 of 35367
Subject: Re: Trading Bond Funds: a Thought Experiment Date: 1/14/2006 5:06 PM
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Opps. Here's a correctio to my correction. I finally did get his name right but the link you need is this:

www.sinica.edu.tw/econ/workingpaper/04-a003-abs.pdf

(And that fails, just Google his name and start tracing out the links.)

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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14961 of 35367
Subject: Re: Trading Bond Funds: a Thought Experiment Date: 1/14/2006 10:20 PM
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Fixed-Income ETF's & CEF's

This is turning out to be an interesting investment problem.

There are only 6 fixed-income ETF's, and not that many fixed-income CEF's, all of which have been nicely collected and categorized by the Closed-End Fund Center.

http://www.closed-endfunds.com/vd/funddata/stats.htm

Of the open-end mutual funds that allow frequent trading, ProFunds has five offerings; Potomac Funds has five offerings; and Rydex has a couple. (Due to their preference for esoteric names, it's hard to tell at a glance exactly what Rydex is offering. But in any case, as with the funds from any family, finding the prospectus and actually reading is where you start.)

http://www.profunds.com/profiles/BondBenchmarked.asp

http://www.potomacfunds.com/performance_info.jsp

http://www.rydexfunds.com/website/fund_info_fset.cfm?home=yes

At this point, which is still survey work, I don't wan to touch on all of the factors to be considered in moving from the idea that bond mutual funds might be traded toward the building of an actual trading system. So let me just do a quickie with the 6 bond ETF's, 4 of which can be dismissed immediately from further consideration.

#1 Anyone who knows enough about TIP (which is the ticker for the fund that holds TIPS as its underlying) to want to trade it is probably already buying his or her own TIPS, holding them to maturity, and doing just fine. In fact, it doesn't make much sense to me to try to trade TIP, which seems to be an institutional gig and better left to the institutionals.

#2 I'd say the same of SHY, IEF, and TLT, which are the funds that hold 1-3, 7-10, and 20+ year Treasuries as their underlying. If you know enough about these funds to want to trade them, you are likely already buying your own Treasuries directly, or else you are trading the futures contracts on them. Additionally, I foresee this problem (although it's been a while since I've done the exercise). By their volume numbers alone, the funds seem passably liquid. However, when you pull 1-minute charts for them, what you see is long periods of trading inactivity, which is “Not-A-Good-Thing”. My guess is that the volumes reported for these funds come from institutionals doing block trades. Chris is absolutely right that good money can be made by front-running the instituationals, but that is a more sophisticated game than I think is appropriate for the “average fixed-income investor”, who really is my target audience, especially when the tradables have such narrow daily, weekly, monthly price ranges. There's just not enough room for mistakes.

An aside: Futures can be traded in IRA accounts, and by “trading” I don't mean zipping in and out of positions. “To trade” is to have a disciplined method of getting into a position, and a disciplined method of getting out. You get in, and you get out. That's a trade, which says nothing about the time-frame in which that trade happens. “In-and-out” is a complete trade. Getting in is just half a trade, and the least important part of the whole process, a point that experienced traders like to make to newbies by posing the following problem:

“You and a monkey are going to be trading partners. One you will do all of the buying, and one of you will do all of the selling. Which job do you want?”

MORAL: “Always assume that a monkey did your buying for you.” It is your job as a trader to manage that position, which includes getting out immediately, with as small a loss as possible, if the position proves to be wrong.”

OK, back to the two remaining, fixed-income EFT's, AGG and LQD. AGG is a fund based on the Lehman Aggregate Bond Index, and you'll find beaucoup information about it when you Google the term. I haven't yet done the same with LQD, which is Goldman Sachs' Bond Index, but I suspect it includes some junk bonds (in contrast to AGG's solely investment-grade holdings) because when I do price chart overlays, LQD is seen to be more volatile. The two track each other closely (and just how closely could be determined by running data sets through Excel and applying the relevant formulas from their stats package). But just by eyeball (which is often as much as is needed), LQD can be seem to swing higher and swing lower than AGG, which suggests that they might be traded as a complementary pair or individually.

A further aside: every time you have enough data to make a comparison or contrast, also make guesses about why you are seeing what you are seeing, and then go looking for confirmation. Don't wait for someone to tell you what to look for. Look yourself, make a guess, and then check it out with other opinions. (And if you think you are right, have the courage of your convictions.) Investing and trading consists in evaluating partial or ambiguous information and making good guesses. If you can be absolutely sure about something, you can also be sure that everyone is sure and there's little profit to be gained. The market doesn't pay for information it already knows. Reward is directly proportional to risk. Risk is inversely proportional to information. Nobody pays you for something they already know.

Another point. AGG is a fund based on an index of investment-grade bonds. The Closed-End Fund Center just happens to have a fund category they call “Corporate Investment Grade” (which they abbreviate as CIG), and they list 5 funds: BDF, LND, ICB, PCN, VBF. When price chart overlays are done and AGG is used as the comparison symbols, you'll see that some of the funds track it quite closely and some do what amounts to their own thing, all of which sets up yet more trading possibilities to consider. (But I'm also running out of time.)

A final consideration. Instant diversification is touted as a reason to buy mutual funds, especially open-end mutual funds, which raises two sorts of problems.

#1 Defining what is meant by 'diversification” is something I know that few investors can do for themselves in any meaningful way. Therefore, they are committing an act of faith that they are, in fact, achieving “diversification” when they buy a fund. “Diversification” is a more sophisticated thing than merely owning a lot of what seem to be different things. But it also needn't be. Diversification is a tool for managing risk. It isn't the only tool, or necessarily the best tool. Therefore, before you do the trade, you need to identify all of your potential risks and all your potential risk-management tools. Sometimes, doing the equivalent of “putting all of your eggs in one basket and watching that basket carefully” is the lesser risk than putative “diversification”, which such an immanent investor as Buffet scoffs at, saying “Diversification is an excuse for ignorance.”


#2 Due to the minimalist reporting requirements that fund investors tolerate, no investor can truly know what she or he supposedly owns. Funds are only required to report their schedule of holdings twice a year, and the reporting can be several months late. (If I'm not mistaken.) So, yes, as of many, many months ago, the fund did own such-and-such-number of such-and–such securities, but who knows what they owned as of yesterday's market close? They know, because they have to mark themselves to market each day within 90 minutes (or whatever it is ) of the market's close. But they won't disclose their most current schedule of holdings to you if you ask them as a shareholder. So, to buy a fund is to make an act of faith, unless it truly is an index fund that holds each component of the index in the exact proportion as the index, which is also almost never the case. (Which is yet another story, but not necessarily “A-Bad-Thing”.) Furthermore, I'd claim that trying to game the index on the basis of the behavior of its components is beyond the abilities or needs of “the average fixed-income investor”. The hedgies, and some heavy-duty traders do it, but they play a different game. There are easier, more sensible ways for an average, small investor to protect and appreciate capital than to try to do things they really have no need to be attempting.

OK, I've gone into more detail than I intended, because I wanted to make some incidental points along the way about the general process of trading. I genuinely believe that the average small investor would be hugely benefited by taking a “traderly attitude” toward her investing, which means getting into her positions in a disciplined fashion and getting out of them in a disciplined fashion. She has no obligation to trade both sides of the market, nor to do her trades quickly. But if, for example, she can look at a chart and immediately see that what is touted to her by her advisor or friends as a “Screaming Buy” is actually a better short, she can protect capital by keeping herself out of trouble in the first place. That's what a lot of trading boils down to, “Chart Smarts” and following a game plan. And in subsequent Chautauquas, which this is turning out to be (shades of ZEN AND THE ART OF MOTORCYCLE MAINTENANCE, right?), I'll talk some more about those game plans as they might be applied to bond funds. (But I'm going to do so in smaller pieces. 1,565 words is almost too big a chunk of text to post or to read.)

Charlie


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Author: Watty56 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14962 of 35367
Subject: Re: Trading Bond Funds: a Thought Experiment Date: 1/14/2006 10:27 PM
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I don't follow it but there is a mechanical investing board that you might check out.

Greg


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Author: imdajunkman Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14963 of 35367
Subject: Re: Trading Bond Funds: a Thought Experiment Date: 1/14/2006 10:36 PM
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Greg,

Yes, there is a mechanical board, which isn't what I'm doing.

I am a fixed-income investor, and I do my posting here.

No one is forced to read my posts. Simply click the "Ignore This Fool" button and move on to other things.

Charlie

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Author: markr33 Big gold star, 5000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 14984 of 35367
Subject: Re: Trading Bond Funds: a Thought Experiment Date: 1/16/2006 6:09 PM
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Yes, there is a mechanical board, which isn't what I'm doing.

I am a fixed-income investor, and I do my posting here.

No one is forced to read my posts. Simply click the "Ignore This Fool" button and move on to other things.


I think you might be confusing "Ignore Thread" with "Ignore Fool" (or sad face icon). "Ignore Fool" will block all your posts when Greg reads the boards, even the threads in which he understands and is interested in. "Ignore Thread", the more appropriate solution here, will block only the thread that Greg is not interested in, but not all other posts of yours in other threads.


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