Tuesday, February 1, 2011

Trading Bands

It is time for the semi-annual trading procedures post. To most this is rather uninteresting reading (only surpassed by Ken’s Modern Portfolio Theory rants) but we feel it is important to continually educate you on the inner workings of Pinnacle. To assist with trading, we invested in iRebal which is a software program designed to rebalance client groups (a collection of accounts owned by the same family) to model or strategy targets. Model targets are the percentage allocations of each security we want to own in the portfolio. The model targets in iRebal are used to rebalance our client portfolios to maintain desired allocations. Additionally, as a tactical asset allocator we often change the model weights to increase or trim current positions, and add or remove securities. In order for these functions to work, we had to make a few decisions that impact the real world application of our trading systems.

The main decision that we are concentrating on in this post is how to set our trading bands. A trading band is the iRebal terminology for the target range for each position in the model. We set our trading bands to +/- 1% which means that a position can deviate from the target by 1% in either direction. As an example, we have a gold position of 3% in our model and due to the trading band a client could hold as little as 2% to as much as 4% and still be “on target.” If the gold position falls below 2% a purchase is initiated, and if the gold position rises above 4% a sale is initiated. The 1% trading band eliminates many trading problems including frequent trading, insignificantly small trades, and helps reduce commission costs incurred when implementing our strategies.

However, due to our methodology of placing incremental trades (our rule is that we may make 1% tactical allocation changes to the model weights) in certain circumstances a client may not receive a trade as anticipated by a change in our model. It is easier to use an example to describe what I mean by the previous statement. Let’s say a client has a 3.2% gold position in their portfolio with a target of 3%, and we change the model target to 4%. The current gold position is only 0.8% below our target weight which is inside our trading band of 1%, so a buy may not be initiated (I use “may” because the trade still could go off depending on the sell side of the trade, but I don’t think we need to complicate the issue in this post). If a 1% change is made to our model targets, we estimate that 15% of clients may not receive the trade. In these cases clients who have been informed about a trade in our managed accounts may wonder if we made a trading error and somehow forgot to execute the trade in their account.

We do weigh all these factors into our decision in setting the trading bands at 1%. Our measured strategy dispersion, which is the variability in client returns in a similar model, is only about 0.47% based on an average of our 5 models. The small dispersion number means we can have confidence that individual Pinnacle clients who own any one strategy will have very similar returns. For this reason we feel the 1% trading band is the proper setting. However, if the dispersion number starts to grow we will have more in depth discussions regarding our trading settings to ensure proper management of all client accounts.