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Alpha Quality and Over-fitting risk

A Presentation by WQ China Advisors


2014.03.10
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TABLE OF CONTENTS

Bias and Over-fitting Risk in Alpha


1.1 Bias in making alphas
1.2 Over-fitting in alphas
1.3 Sample alpha idea improvements

Make High Quality Alphas


2.1 Think deeper and differently
2.2 Good research habits
2.3 What if an alpha doesnt work?

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1. Bias and Over-fitting Risk in Alpha


1.1 Biases:

Data mining bias


Data mining is easy, but finding alphas that work out-of-sample is not

Survival bias
You can always find something that works if you try enough times

Small cap bias


Alphas that only work on small cap stocks cannot make real money

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1. Bias and Over-fitting Risk in Alpha


1.1 Biases (continued):

Delay-0 bias
Delay-0 is harder to trade and simulated performance can be too good
to be true
Mixed-signal bias
Alphas that are based on mixing signals do not add value to existing ones
Over-fitting bias
Over-fitting may not improve or even hurt Out-of-sample performance

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1. Bias and Over-fitting Risk in Alpha

1.2 Overfitting: risky and bad for out-sample


Robustness checks
Check a parameter fitting in multiple universes/regions

Keep it simple
do not make it complex unless necessary
Avoid using too many conditions
Conditions are easy to fit but risky
Only accept significant improvements
Ignore if the improvement is trivial

Do not fit specifically for one year or one drawdown


focus on the overall performance improvement

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1. Bias and Over-fitting Risk in Alpha

Only a good out-of-sample alpha is a real alpha


Do not fit specific for one instrument or industry
You can always find one instrument or industry that performs well or
badly, but it is not statistically significant
Use reasonable parameters
For example, for days: use one week or one month
Idea and logic behind
The best alpha is one that is based on logical ideas and you are
confident and clear about how and why it works

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1. Bias and Over-fitting Risk in Alpha


1.3 Sample of alpha idea improvement
alpha = -returns?
Paper / Thoughts -> Ideas - > Implementation
1) Read paper about price/volume interactions
-> will larger volume lead to more reversion?
-> -returns * tsrank (volume, 20)
2) Read paper about annual price momentum
-> Will larger annual return lead to more reversion?
-> -returns * (1 + rank (sum(returns,250)))

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2. Make High-Quality Alphas


Why alpha works?

Market inefficiency
Price/Volume alphas

Coverage advantage
Fundamental alphas
Speed advantage
High-freq alphas, News/Events alpha
Most single alphas do not make money by themselves
If everyone knows one signal or idea, the signal / idea disappears
We need to think deeper and differently from others

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2. Make High-Quality Alphas


Think in terms of arbitrage
Relative value
After neutralization, we are trying to predict the relative value
change instead of absolute value change
Change of value
Value may be already reflected in price, but change of value
may still have opportunity
Knowledge arbitrage
If we know that everybody is already using some signal A,
how to make use of this fact

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2. Make High-Quality Alphas


Good Alpha Research Habits

Bad Alpha Research Habits

Keep It Simple Stupid


Pure signal

Data mining

Try new ideas

Mixing signals

Try new data

Combining well-known signals to


make new alphas

Try new regions


Try new instruments

Fitting correlation

Crossover
Data, region, instruments, etc..

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2. Make High-Quality Alphas


What if my alpha does not work?
Am I thinking in the correct way?
Trend in time-series may become mean reversion in cross-sectional

Is my implementation good?
Many ideas can work by changing the implementation

Is my model data-mined?
Outliers? Too short a back test period?

Am I using the wrong universe?


Should I expand or contract my universe? Are certain types of stocks acting
as exceptions that are inconsistent with my model?

Should I try new ideas?


Read papers, blogs, websites

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THANK YOU

TM

TM

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