Portfolio Design

Advanced concepts in stock investment portfolio design.  Fundamentals, technical analysis and many other related topics are discussed.

Capital Strength Stock Portfolio Part 3 - The Simulation

This is the final installment part of a three part tutorial on how to design a capital strength portfolio based on the First Trust Capital Strength ETF.

Part 1 was dedicated to the construction of the custom stock universe.

Part 2 covered the stock ranking system, used to rank the stocks according to lowest three month and one year volatility. Part 3 completes the design and simulation, implementing the simulation setup and Buy/Sell rules, then running the backtest.

Stock market analysis fueled by Portfolio123.

The Capital Strength custom universe and ranking system are available on Portfolio123 here:

Index Methodology

Before proceeding into the simulation design, it is important to understand how the ETF deals with reconstitution, rebalancing, and stock eligibility. In general, ETF fact sheets and prospectuses do not give out this kind of information, but instead reference an equity index. In the case of the First Trust Capital Strength ETF, the NASDAQ Capital Strength Index is identified as the governing index. The methodology behind this index was found using a Google search and is located here: The Capital Strength Index Methodology.

The key points of interest are underlined in red in the documentation below.

Important points from the NASDAQ: The Capital Strength Index Methodology

The eligibility criteria "Evaluation" dates are listed as the end of December, March, June, and September. According to the documentation, the rebalance dates are two-to-three weeks later (third Friday of the next month). Unfortunately, Portfolio123 cannot handle an eligibility date separate from the rebalance date.  Therefore the evaluation, rebalancing, and reconstitution will all be done at the end of December, March, June, and September. This means that this simulation/portfolio will be front-running the ETF, which is not necessarily a bad thing. In addition, the rebalancing will take place the last week of the quarter, not the last day. This makes the simulation simpler to implement as daily rebalancing is not necessary. Within Portfolio123, the rebalancing/reconstitution requirements will be handled in the simulation Sell rule(s).

Also, if a stock no longer meets the eligibility criteria, it is removed from the index immediately, and is not replaced until the next rebalance period. With Portfolio123, this requirement is implemented by dropping the stock from the custom universe. (This is an option specified later on in the setup when the stock universe is selected.)

Simulation Setup

A simulation is created by clicking on SIMULATED -> Portfolio from the PORTFOLIO pull-down menu provided at the top of the Portfolio123 window.

Selection of SIMULATED Portfolio from the PORTFOLIO pull-down menu

At the top/left of the screen, select New -> Simulated Portfolio (Stock).

Selection of a new simulated portfolio

Starting with the GENERAL tab, set up the simulation as shown below by providing a name for the simulation, selecting variable slippage, weekly rebalance period, and allow sold holdings to be re-bought at current rebalance.

Capital strength simulation: General setup

Proceed to the POSITION SIZING tab and set the % of Portfolio Value to 2.0, and Constraints to 10 % From Ideal Size. This specifies the approximate number of positions to 50, the same as for the Capital Strength ETF.

Capital strength simulation: Position sizing

Next, migrate to the UNIVERSE & RANKING tab and select the stock universe created in Part 1, and the ranking system created in Part 2 of this tutorial. Also verify that Force Positions into Universe is set to No. This setting causes stocks that no longer meet the criteria to be dropped from the stock universe immediately.

Capital strength simulation: Universe and ranking system selection

Now go to the BUY tab so that the Buy rule(s) can be specified. This is where the industry weight requirement is implemented.  The requirement from The Capital Strength Index Methodology is:

"If an Industry has a weight greater than 30%, the highest ranking security by volatility will be removed and replaced with the next eligible security (e.g. the 51st ranked by volatility) from a different Industry."

The methodology refers to Industry in the context of the Industry Classification Benchmark. The terms "industry" and "sector" are reversed from the Global Industry Classification Standard (GICS) taxonomy.  Portfolio123 uses GICS, so the Buy rule will be written with sectors in mind as opposed to industries. Note that GICS now has eleven sectors, with Real Estate being split out from Financials. ICB still has ten sectors. For the purposes of this tutorial, this difference will be ignored.

The sector weight requirement is implemented using the Buy rule: SecWeight<30. This implies that no stocks from a given sector will be purchased if doing so will push the sector weighting over 30%.

Capital strength simulation: Buy rule

Now go to the SELL tab to enter the Sell rule(s) and enter the rule: Mod(Month,3) = 3 & MonthDay > 23 & MonthDay <= 30. This rule states that every third month (March, June, September, December) between the 24th and 30th of the month, all of the stock holdings will be sold. The last day of the month is the 31st in some cases.  This algorithm ignores the 31st for ease of implementation i.e. exceptions don't need to be accounted for. When all of the stocks are sold, this results in a reconstitution of the portfolio and also reset back to equal weightings. The Sell rule does this quarterly, which is what is required.

Capital strength simulation: Sell rule

Now skip to the PERIOD & RESTRICTIONS tab and set the Start Date - End Date to the maximum that your membership will permit. Then cliclk on RUN SIMULATION.

Capital strength simulation: Setting the time period

The simulation will look similar to the backtest results shown below.

Capital strength simulation: Backtest results

The trade statistics are provided below. The average return for realized trades was 5.78%, a high enough figure to make this strategy practical for trading in real life.

Capital strength simulation: Trade statistics

The user can now transform this simulation into a portfolio that can be traded or alternatively tailor the simulation before doing so.  One modification might be to reduce the number of stock positions from 50 down to a smaller number such as 10 stocks. This could be done by use of additional Buy rules or modifying the POSITION SIZING, then re-running the simulation.

The complete simulation from this tutorial can be found here:  Tutorial: Capital Strength.