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A Better Way To Run Bootstrap Return Tests: Block Resampling

Developing confidence about a portfolio strategy's track record (or throwing it onto the garbage heap), whether it's your own design or a third party's model, is a tricky but essential chore. There's no single solution, but a critical piece of the analysis for estimating return and risk, including the potential for drawdowns and fat tails, is generating synthetic performance histories with a process called bootstrapping. The idea is based on simulating returns by drawing on actual results to see thousands of alternative histories to consider how the future may unfold. The dirty little secret in this corner of Monte Carlo analysis is that there's more than one way to execute bootstrapping tests. To cut to the chase, block bootstrapping is a superior methodology for asset pricing because it factors in the reality that market returns exhibit autocorrelation. The bias for momentum - positive and negative - in the short run, in other words, can't be ignored, as it is in standard bootstrapping.

There's a tendency for gains and losses to persist - bear and bull markets are the obvious examples, although shorter, less extreme runs of persistence also mark the historical record as well. Conventional bootstrapping ignores this fact by effectively assuming that returns are independently distributed. They're not, which is old news. The empirical literature demonstrates rather convincingly a strong bias for autocorrelation in asset returns. Designing a robust bootstrapping test on historical performance demands that we integrate autocorrelation into the number crunching to minimize the potential...


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