This week I am off to the wall street green trading summit on behalf of the seeking alphasters. Thanks lads. I thought I would take a look at how the emissions (carbon) market is evolving from a traders and economic efficiency perspective. Here is a snapshot of carbon prices or the right to emit 1 tonne of carbon about 11 euros:
Truly efficient markets have few opportunities for naive trading strategies to work long term. A naive trading strategy is something so blindingly obvious only your brother in-law or crazy uncle thinks it will work. Much to your and those pesky economists frustration it often does work.
I spent +20 years doing quant stuff and think about numbers and culture in my spare time, so cranking out naive spreadsheets is simple. caveat emptor, slippage, liquidity and real concerns haven't been addressed here, so your mileage may vary significantly. This article is released to provoke thought not trades per se.
Here is the data and the trading system related to this article in Excel 2007.Download MOZ9 naive strategy
The original Naive strategy for equities is buy and hold
Naive trading or allocation strategies are the baseline by which all alpha or performance should be measured. OK, I know the Beta puritans are screaming EMH, frontiers etc., but bear with me.
A naive strategy is used as a test or null hypothesis of other approaches or processes you are going to employ. If you can't beat the naive approach then just join it. Yes, value investing is a trading process which can be compared to by and hold. HT: for the fundamentalists out there.
Markets are not stable they typically evolve or "regime shift" over time, just like an ecology. These regime shifts typically involve participants eliminating or diminishing naive strategies for periods of time as their behavior (rent seeking) leads to shifts. Most likely some physics student quant guy will eat your naive lunch with a souped up server looking at Lyapunov exponents and slicing VWAP into ever tinier pieces net hops and milliseconds for execution.
I took a look at an Emission market traded in Europe to see how a Naive strategy would perform. Here is the market and instrument description.
Below is the outcome, a 1.96 Sharpe ratio* with a strategy using the cunning logic: if today was up, buy tomorrow, else short tomorrow. The Sharpe or risk reward ratio of index buy and hold equities is usually around 0.50. So this naive strategy at first glance appears to yield roughly 4X better risk return in what is probably a low-correlated (as traded) asset class.
There are major caveats here, the logic implies, you can tell moments before the close which trade to make and there are no transaction costs or taxes removed. Also please note this is a futures contract, so the volume is anemic to non existent for 2-3rds of the contract life. you need to research rolled contracts to really see what is under the hood here. Look at the data yourself, I included the volume in the spreadsheet.
The interesting thing is that a naive strategy appears to provide interesting returns. For those unfamiliar with a sharpe ratio, if one were to de-leverage the position so that the risk profile had a volatility of 15% per annum which is less than the historical returns of the stock market, the returns would be greater than 29% per year.
This is an interesting example of a young market where the naive strategy still appears to offer significant alpha returns. My thesis is, because there isn't liquidity and more sophisticated participants playing yet, the various Naive niches, like and ecology are unexploited. Of course lucrative naive approaches will eventually attract participants and liquidity, leading to a regime shifts. Strategies or market process are chaotically unstable based on simple agent behaviours and opportunity seeking.
I am not advocating a trading strategy or process in this article, merely highlighting an interesting young market and the use of studying naive approaches to assess trading allocation processes and their viabilities. If you run a fund and want to talk quant carve out, shoot me an e-mail, getting portfolio level Sharpes north of 2.0 isn't really that tough.
*m sharpe didn't have an annual risk free rate removed, to simplify leverage assumptions etc.
