Trade Advisor

The Optimizer finds optimal portfolios, indicates when you should trade, and now advises you on how to trade. Subject of our latest patent application, the separately licensed Trade Advisor offers guidance as to what trades most efficiently bring your held portfolio closer to a targeted optimal, filtered, or directly input portfolio. In the case of a targeted portfolio on the efficient frontier with a corresponding previously run rebalance test, it also calculates rebalance scores, thus laying out the trades with minimum turnover necessary to reach a portfolio that is statistically equivalent to the targeted portfolio. (For information about using the Trade Advisor with investable portfolios, see the Trade Advisor and Post-Optimization topic.)

How to Use the Trade Advisor:

1. Optimize and run the rebalance test first for best results.

2. Access the Trade Worksheet and Trade section of the NFA ribbon by enabling the Trade Advisor in the Worksheet Section of the Display Menu.

3. Choose a held portfolio (either initial or reference) from the Choose Held Portfolio drop down menu in the ribbon, or complete the column manually. The held portfolio is the starting point for the trade advice. If you enter the portfolio manually, the weights should normally sum to 100%. Otherwise a jump will appear between the held and first advised portfolios since all the advised portfolios are constrained to sum to 100%.

4. Select a target portfolio.

   • Choose the portfolio type from the drop down menu: direct input, a portfolio from the optimal frontier, or a reference portfolio.

   • If you chose optimal, use the slider to target the desired portfolio or type the desired portfolio rank in the cell beneath the slider and above the portfolio weights.

   • If you chose direct input, enter asset weights of the desired portfolio in the Target Portfolio column.  The portfolio should normally sum to 100%.

5. To find trades which simply minimize turnover for a given tracking error or rebalance property, leave all of the entries in the Relative Trading Cost column at 100%. To prioritize trading of an asset, lower this number, and to discourage trading, raise the number corresponding to the asset in question. Note that this column replaces the "Constrain to held" column from versions of the AAS prior to 6.6, which did not allow for prioritizing an asset.

6. Select a portfolio on the trade advice frontier. There are three criteria you can use to select a portfolio.  After you do so, the Trades column displays the differences from the held portfolio and the Advised Portfolio column shows the selected portfolio.

• Turnover Percentage: Use the turnover percentage slider in the Advised Portfolio column, or enter a turnover percentage in the cell beneath the slider, to select the portfolio with the turnover percentage closest to your input percentage.

• Tracking Error: Enter the desired tracking error in the field at the bottom of the page to select the portfolio with the tracking error closest to your input tracking error.

• Rebalance Percentage: Enter a rebalance probability in the cell beneath the slider to select the portfolio with the rebalance probability closest to your input probability.

7. Sometimes the minimum turnover minimum tracking error path to the target portfolio is such that one or more portfolio weights travels outside of the interval bracketed by the held and target portfolios. Trading to such a portfolio and subsequently trading to optimal will incur more total turnover than trading directly to optimal. If you wish to disallow trades with weights outside held and target, check the Enforce Trade Bounds box in the ribbon.  All advised portfolios then will have asset weights bounded by held and target asset weights.

8. Interpret results. The Advised Portfolio Composition Map appears to the left, and the Advised Portfolio Statistics plot, a plot of the tracking error against turnover, appears to the right. If the target is an optimal portfolio and a valid rebalance procedure has been run, the rebalance score for each portfolio on the trade advice frontier will also be plotted in the right graph.

9. Once you have the Trade Advisor set up, you can run it with the Robot if you have that licensed.

What the Trade Advisor Does:

The Trade Advisor finds the set of portfolios which minimize turnover, or total relative trading cost, for given tracking error from the target portfolio between held and target, or equivalently, which minimize tracking error from the target portfolio for given turnover, or total relative trading cost, between held and target. This produces a frontier of portfolios which are efficient in the sense of solving the optimization problem which we call the trade advisor frontier.

Technically, Trade Advisor performs a calculation having the form of a Markowitz mean-variance optimization. The quadratic component of the Trade Advisor’s optimization criterion is identical to the squared tracking error from the target portfolio. This is convenient since the Michaud-Esch rebalance score is a monotone function of this quantity, when the target is a portfolio on the Michaud efficient frontier. In that case, if the Michaud-Esch rebalance procedure has been run, rebalance scores are available for the entire trade advisor frontier. The software then plots the rebalance scores for the frontier in a separate chart, and displays the score for the selected trade-advised portfolio. When the target is a Michaud-efficient optimal portfolio, the Trade Advisor shows the minimum turnover portfolio that passes the rebalance test. Because of the nature of positivity-constrained Markowitz optimization, the trade path breaks the trades into separate components, and often many assets will not need to be traded to achieve optimality in a statistical equivalence sense. This property is useful to client management in recommending only a few trades to bring the client portfolio back into line with minimal operational complexity. Managers may prefer to go a little further on the trade advisor frontier towards the target to push the rebalance score below the threshold and leave room for drift so the portfolio stays in the “optimal zone” for a longer period of time. Choosing a suitable trade target is at the discretion of the manager, but the Trade Advisor can be helpful in showing the most efficient path to Michaud optimality.

Additional flexibility is provided to the manager using Trade Advisor with the Enforce Trade Bounds checkbox and Relative Trading Cost column. The Enforce Trade Bounds checkbox adds upper and lower bounds at the upper and lower of the held and target portfolio weights for all assets not constrained to the held weights, and the Relative Trading Cost column can prioritize or deprioritize the trading of assets relative to others. The Enforce Trade Bounds feature is useful when designing an incremental trading strategy for the client. It is occasionally possible for some asset weights on the trade advisor frontier to be larger or smaller than their weights in either the held or target portfolio. If the goal is to ultimately have the client hold the target portfolio exactly, the manager may not wish for a partial rebalance which moves asset weights further away from those in the target portfolio, as such trades will have to be undone in remaining rebalances, incurring unnecessary round-trip trading costs. In such instances, Enforce Trade Bounds will be useful in order to ensure that all asset weights move in the direction of the target portfolio’s asset weights, and never in the opposite direction.

Trade Advisor and the Rebalance Test:

The Trade Advisor shows the fastest trading path to statistical optimality as determined by the rebalance test. The "fastest trading path" is defined by total relative trading cost, or turnover if all the relative trading costs are equal. The optimization within the trade advisor minimizes the tracking error for optimal for a given turnover/total relative trading cost. Since tracking error from optimal also determines the rebalance score, the need-to-trade score is also shown on the trade advisor graph, keyed to the axis on the right-hand side. Rebalance scores can be especially useful in determining a threshold for trading on the trade advisor frontier. This could be used to design a policy to keep the portfolios under a particular score at all times via regular monitoring the score in tandem with judicious trading and partial trades determined by the trade advisor. These types of policies must be determined appropriately for each strategy by the manager.