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SYSTEM PORTFOLIO

Nick Radge

This report may contain advice that has been prepared by Reef Capital
Coaching ABN 24 092 309 978 (“RCC”) and is general advice and does
not take account of your objectives, financial situation or needs. Before
acting on this general advice you should therefore consider the
appropriateness of the advice having regard to your situation. We
recommend you obtain financial, legal and taxation advice before
making any financial investment decision.
Past performance is not a reliable indication of future performance.
This material has been prepared based on information believed to be
accurate at the time of publication. Subsequent changes in
circumstances may occur at any time and may impact the accuracy of
the information.
Simulated or hypothetical trading results may contain inherent
anomalies that cannot be replicated in the real world. As such, any
performance results shown herein may be over or under exaggerated.

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SYSTEM PORTFOLIO

Introduction.............................................................................................3

What is a trading system? .......................................................................4

Why use a trading system? .....................................................................4

Robust Strategies ....................................................................................5

Testing on Historical Data ......................................................................6

Back testing / Forward testing ................................................................7

The Chartist Systematic Portfolio – Outline...........................................7

Performance ..........................................................................................10

The Bottom Line...................................................................................11

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Introduction

I have been trading systems since the mid-80’s, although I did not really
enter the arena of serious system testing, design and trading till the mid-
90’s. The first trade I ever made was actually based on a system, although
at the time I did not think of the concept like that.

This discussion paper is design to introduce you to system trading in


general as well as the new System Portfolio within The Chartist.

A polite word before I go on. This system is not designed to be a money


making machine. Should you want a money making machine then you
should look elsewhere. This system is designed to:

(1) Keep you on the right side of technically strong stocks


(2) Keep you on the right side of fundamentally strong stocks
(3) Reduce the volatility of a buy and hold portfolio
(4) Increase the risk/reward of a buy and hold portfolio by a
significant amount
(5) Revert to cash during prolonged bearish periods
(6) Simplify the stock selection from a vast universe
(7) Allow you to participate in the market knowing that the
implemented strategy has shown an acceptable positive expectancy
in the past.
(8) Remove excess noise from the decision making process.

As you can see I have not made any promises about future gains and as
you will see later on the gains shown here are certainly not startling.
However, once you look deeper into the volatility of the portfolio and the
ease and robustness at which it operates, you may find that it appeals a lot
more than a first glance.

Lastly I would like to point out that system testing is not an exact science.
I have no doubt you may question certain aspects of this testing criteria,
however I will attempt to discuss the logic of the various parts as we go
though the discussion.

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SYSTEM PORTFOLIO

What is a trading system?

A trading system is a set of rules designed to extract profits from the


markets. Essentially every trader, fundamental or otherwise, follows
some type of system whether that is consciously or sub-consciously.

These rules represent various inputs that can be simple or complex. These
rules encompass inputs such as:

 Filtering device to select which stock/s to trade


 An entry trigger
 A protective stop
 A trailing stop
 An exit mechanism
 Money management

A trading system can be designed to participate in any market condition


and for any timeframe.

A mechanical trading system is one where the inputs can be programmed


into a computer and then tested using historical data. This testing allows
the user to quickly see whether or not the system is valid and whether or
not the nuances of the system are appropriate for the users’ objectives and
risk tolerances. The Chartist System Portfolio is a mechanical system.

Why use a trading system?

There are various reasons why a trading system is useful.

The main reason is that the concepts and rules can be tested on historical
data to see if the strategy is in fact valid. If testing is done correctly, that
is with robustness and without curve-fitting, then there is a reasonable
probability that the strategy will continue to work into the future. If the
testing is done incorrectly then there is every chance that the strategy may
look good on paper, but not work into the future

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Another reason for using a trading system is to alleviate emotion from the
trading process. If you are happy with the historical test results, you may
well be more inclined to follow the rules of the system into the future
without question or emotion. To be able to follow a system without
question will enable the complete removal of fear, greed and ego from the
decision making processes.

The bottom line philosophy for a system trader is to:

(1) Create a strategy that has a acceptable boundaries of risk and


reward
(2) Validate the strategy using a non-biased computer
(3) Trade the strategy as planned

Robust Strategies

Many trading systems available by vendors are not robust. They are
tested using very specific rules for one stock and not another. This creates
an illusion of an extremely profitable strategy, but unfortunately one that
will most likely fail to work into the future. Stocks by their very nature
will change their personalities over time. Some trend very well for a
period, then chops back and forth for another period. Designing a system
based solely on the trend period will create very different results for the
choppy period. The same goes for designing a system for a specific stock.
If it changes its personality then you will start having losses and will need
to either redesign the system or look elsewhere. Either way you will
continue to chase your tail as the stocks personality changes.

A robust strategy on the other hand is one that has the same rules
regardless of the stock being traded. Whilst the results may not appear to
be that glamorous on first glance, it should however continue to perform
into the future as it has done in the past.

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A key philosophy of mine is that if you are able to understand why your
strategy will make money then you are a lit better placed to actually
continue to profit from it into the future.

The Chartist System portfolio uses the exact same rules on every single
stock. Whilst profitability varies according to the current personality of
each individual stock it important to note that a profit is generated on
90% of all stocks for the test period. The stocks in the universe are
diverse; from large corporates like PBL that have been around for many
years to small exploration companies that have only just been listed over
the last few years.

Whilst we may achieve better results by attempting to pick the next hot
sector, or the next hot stock, we will run into problems with deteriorating
robustness at some stage. The rule of thumb is that is the system looks too
good to be true then it usually is.

Testing on Historical Data

The period over which a test is conducted will always be a topical point.
Some say the further back the better. Does BHP have the same
personality that it did in 1986? Most likely not. Therefore is it plausible to
test back 20-years or longer? My personal opinion is no. Markets and
environments have changed over the longer term and placing too much
emphasis on data from 25-years ago would not be deemed robust.

The opposite is also true. Testing the system since 2003 would offer
results far superior than what could be expected over an average term.

Sadly we are lucky enough to have a recent history that offers a variety of
market environments to test in. I say sadly because one of those
environments was September 11. Since 1999 we have seen some
extremely broad market conditions; the Tech crash and Sept 11 are both
price shock occurrences, 2002 offered a reasonable bear market and the
strong run up since 2003 shows a very powerful bull market. Therefore I
have started the test phase from 1997 to encompass all these scenarios

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and we should get a very good feel on how the system will perform
should such events occur again in real time trading.

Back testing / Forward testing

It is desirable for systems to be tested on various parts of the data to


check for consistency. As an example, if we have 15-years worth of data
we will design the system on the middle 5-years. We will then run the
system on the first 5-years and also on the last 5-years. The theory is that
if the system designed around the middle period is robust, then it should
work equally well on the first and last periods.

The Chartist System Portfolio has not been tested across various data sets
for one very strong reason; because there is no optimisation within the
system (all entry/exit parameters are the same for each individual stock –
see Robust Strategies above). Had we attempted to make the system more
attuned to each individual stock then yes, we would be advised to test
across different sample periods of data.

In my opinion, the downside of not tuning each individual stock does not
outweigh the loss of robustness or potential for curve fitting. I would
prefer to know that the system will always work – maybe not at its
pinnacle – but work as expected during all market conditions without
needing interim tweaking and re-assessment.

The Chartist Systematic Portfolio – Outline

This discussion is general in nature. The specific details of this system are
not disclosed for various reasons, one of which is that this model is a
variant of a commodities model that I created back in the late 90’s and is
still effective today.

The universe of stocks selected to be tracked by the Systematic Portfolio


are those that are have an average broker consensus of Moderate Buy or

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Strong Buy. All stocks that are ranked as Hold or below are ignored. This
broker consensus is collated from Thompson First Call via the Huntley
Equity Review. The obvious point here is that we allow the so-called
experts to put forward their fundamental opinion, but allow the price

activity and system logic to make the actual decision whether to buy the
stock or not. One shortfall of this method is that the universe of stocks
will change over time. Those stocks ranked highly now may not be
ranked highly in 2-years time. Whilst they can be eliminated in due
course, what this will do is perhaps put the testing into question. The
historical testing may cover stocks that were not ranked highly in the
past, but are so now. This is where system robustness comes into the fray.
We must assume that the addition of strong fundamental consensus
should only add benefits to the criteria, not detract from them. Either
way, the system was still going to give a buy or sell signal regardless of
the consensus.

The Chartist Systematic Portfolio is an intermediate to longer-term trend


following system. Its attempts to locate and exploit significant market
trends and in the case of the ASX the trends we’re looking for are bullish
in nature. Every sustained trend will begin with a breakout from a trading
range. Unfortunately every trend that cannot be sustained will also
commence at the same point. The entry logic within Systematic Portfolio
attempts to differentiate between a false breakout, which is a trend that
cannot be sustained, and a breakout that may lead to a sustained trend.
During bearish market environments, where markets go sideways to
down, the entry logic will not allow the system to take new positions and
any broad market declines will see the system slowly go to cash. This is
clearly shown in the equity curve shown later.

In the following chart, VGL, even though ranked highly by broker


consensus, dropped over 50%. You can see at the top left of the chart that
the system initiated a position, saw the warning signs and exited before
the dramatic collapse. During that declining period, and the false price
spikes that followed, the Systematic Portfolio was able to ignore the
strength and not enter into the market.

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The major attribute of the Systematic Portfolio is the unique exit criteria
used. This exit criteria attempts to remove the position at an optimal point
in the trend, not necessarily optimal in terms of length of trend or profit,
but also in terms of volatility of the trend. As such there may be times
where the position appears to be moving very well yet the system decides
its time to exit.

A very good example of this is shown in the following chart of GTP. You
will note that the system had been long from $1.05 for the move up (not
shown) but then exits near the absolute highs. The stock does travel
slightly higher, but then declines almost 50%.

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Performance

A basic trend following system is in fact quite easy to create. As an


example, buying a stock when it makes its highest peak for the last 200-
days then exiting should it close below it 200-day moving average will
give positive results. However, what will occur is that the returns and the
risk slowly revert back to the index so one may as well be invested in an
Index Fund and walk away. The goal is to beat the index with the same
risk, or perform as per the index with less risk.

Here are some basic facts about the system test between 1997 – Present:

 90% of all stocks in the current universe show a net profit


 21% of all stocks in the universe have never had a losing trade

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 Of every trade made, 61% are profitable


 On each stock the average total profit was $8,6581
 On each stock the average maximum drawdown2 was $2,308
(23.08%)
 The average profit was 4.85 times the average loss
 The Profit Factor was 6.333
 The combined total profits from all signals was $621,000

The Bottom Line

The comparative equity curve of the following page shows the


performance of the System Portfolio verse the XAO. The benchmark
XAO can be interchanged with any Benchmark you desire. I have used
the XAO because I have the data going back that far and it is not too far
distant from other popular benchmarks.

Notes:
 Dividends have not been included
 Re-investment of capital has not been included.
 No leverage has been used.
 As the system enters and exits at the market open, no slippage has
been included
 Commission of $20 per transaction has been included
 Each transaction was to a value of $10,000

Special Note:

Because of the difficulties of coding the system into Portfolio Software we


were unable to limit the number of transactions to a maximum. There
would be times therefore that 20 positions would be open at once, each

1
Basis a purchase of $10,000 per transaction
2
Maximum Drawdown is the largest decline in equity from a peak to a trough
3
Profit factor measures “traders comfort” The higher the number the more comfortable the system is to
trade. Profit Factor is calculated by dividing the net profit by the net loss. Because some stocks (20)
have never experienced a losing trade the profit factor number was distorted. As such any stocks that
has never had a losing trade was removed from this calculation.

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being $10,000 each. Therefore a very general start balance of $200,000


could be assumed for this test.

With this in mind you can see that the System Portfolio has quadrupled
($621k profit + $200k start balance = $821k) its money compared to the
XAO doubling during the same period or an outperformance of 2x. It has
also done so with a 50% decline in the maximum drawdown.

Because of the assumptions we have made it is now essential to water-


down the end result by 50%. Either way you wish to look at it, the
Systematic Portfolio has offered a substantial increase in the risk/reward
profile, plus the other benefits listed at the beginning of this document, of
a buy and hold portfolio.

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