Arti cial Intelligence Systems and Investor Suitability ... · Seligman New echnologiesT Fund II, Inc., No-Action Letter, IM Ref. No. 20011019110 Set a precedent allowing hedge funds

IntroductionOverview of MLTS Algorithm

Selection ProcessComparison to Benchmark

Arti�cial Intelligence Systems and Investor

Suitability for Hedge Funds

Michael Kotarinos1 Doo Young. Kim2 Chris P. Tsokos1

1Department of Mathematics and Statistics

University of South Florida

2Department of Statistics

Arkansas State University

Frontiers of Statistics 2018

Kotarinos, Kim, Tsokos Hedge Funds



Outline

1 Introduction

2 Overview of MLTS AlgorithmAsset Allocation StructureValue Driven Fund

3 Selection Process

4 Comparison to Benchmark




Disclosures

The information presented in this presentation is notconsidered �nancial or legal advice.

This is an academic exercise and as such if you trade on thesestrategies or ideas and lose money do not sue me.

Parts of the regulatory structure were prepared By EcclestonLaw for Solarbeam Capital LLC. These ideas are not all myown and some of the intellectual property presented today isused under license by Solarbeam Capital LLC.




Introduction

Introduction to Some Rules and Regulations Regarding HedgeFunds

Overview of MLTS Algorithm Combined with Preferences overRisk and Suitability

Comparison to Benchmark




Hedge Fund Regulations

A Hedge Fund is an SEC-Exempt Mutual Fund

Has a compliance o�cer or representative to ensure the fundstill complies with some non-exemptable SEC regsHas an underlying Investment Advisory that provides guidanceon asset allocation and selectionHas a parent fund that is managed by the advisory subsidiary

Under the Investment Advisers Act of 1940, InvestmentAdvisers cannot charge a performance Fee

Seligman New Technologies Fund II, Inc., No-Action Letter,IM Ref. No. 20011019110 Set a precedent allowing hedgefunds to operate outside of this domainThere is an exceptions for Mutual Fund Fulcrum Fees underthe 1970 Congressional Revision, with some restrictionsA 1985 Revision also allows for performance fees for �quali�edclients�




I have an Automated Trading Algorithm! Should I Register

a Hedge Fund?

ProsPerformance Fee is fair game (�2 and 20�)There are fewer restrictions on client managementAre generally allowed to be more aggressive without gettingsued

ConsExpensive to set upLengthy private o�ering memorandum is required

The SEC is displeased with the spread of �o� the shelf�memorandums, so this is a great way to get �ned, sued, andor disciplined.Management must give a lengthy discussion of how exactly

the algorithm works and then are prohibited by law from

deviating.

If the algorithm does something illegal your compliance o�cergoes to prison




Maybe an RIA Then?

Pros

Disclosure Notice instead of a memorandum with far fewerdetailsMinimal Start-Up CostsSometimes Insurance Costs are Cheaper, but far more limitedin scope and options

Cons

Shorting can draw the SEC's attention and scares o�underwritersHarder to e�ectively mix in derivativesEach state where one operates has di�erent requirements andrestrictionsHave to operate under state law with under $100 Million AUMand under SEC laws with over $100 Million AUMNo Performance Fees




Unavoidable Issues

Discussion of Risks is not considered su�cient. You cannotindemnify yourself when you take on a client.

Tendency for �momentum tracking� if done by inexperiencedanalysts.

Clients must not only understand the risk, but must besuitable and have a risk pro�le that matches your algorithm'sunique characteristics. How does one evaluate this?

It is assumed that the algorithm operates independently of themarket. This is not true.

Market sell-o�s based on buy/sell ordersVolatility spikes on vixMarket Manipulation Exploiting Liquidity Premiums




AllocationValue Driven Fund

Outline

1 Introduction


3 Selection Process






Asset Allocation

Movement from traditional asset management options (mutualfunds, self-managed brokerage accounts) to lower cost options

ETFs for mainstream consumersO�shore hedge funds for sophisticated investorsLow cost brokerages that cater to various investor classes

Are actively managed funds dead, about to be taken over bymachine learning algorithms?

Not yet (returns on automated trading still very poor)Actively managed funds can cater to unique needs and desiresof clientsActively managed funds can o�er a level of customizationcurrent machine learning algorithms do not yet provide





Asset Allocation

Movement from traditional asset management options (mutualfunds, self-managed brokerage accounts) to lower cost options

ETFs for mainstream consumersO�shore hedge funds for sophisticated investorsLow cost brokerages that cater to various investor classes

Are actively managed funds dead, about to be taken over bymachine learning algorithms?

Not yet (returns on automated trading still very poor)Actively managed funds can cater to unique needs and desiresof clientsActively managed funds can o�er a level of customizationcurrent machine learning algorithms do not yet provide





Outline

1 Introduction


3 Selection Process






Goals of a Value Driven Fund

Invest in undervalued assets based on discounted cash �ows

General Equilibrium Theory theorizes these assets should rise invalue over timeEven if assets take a while to correct, strong cash �ows shouldreward investors even if under-pricedFocuses on accounting statements and books, rather thanmomentum or highly speculative positions

Avoid ��ashy� assets with weak fundamentals




Selection Procedure

Phase 1

1 Construct a database of large-cap stocks. Run aMLTS clustering algorithm on each sector,breaking o� stocks into individual groups.

2 In each of these groups, sub-cluster based o� theselection criteria.

Phase 2

1 Select the stocks from the sector matching theuser's preferences (such as value driven) and addthem to a portfolio.




Selection Procedure

Phase 3

1 Weight the stocks so that each stock's representation is equivalent todesired weight

2 Use GARCH and ARIMA models to estimate the portfolio's risk andreturn over time.

3 Measure the risk/return pro�le of the portfolio. Drop and add the singlestock that results in the largest return in the risk return pro�le.




Selection Procedure




Selection Procedure

Sector 1 Example Follows (of 8 sectors)

Also includes example for block 1 of sector 1

Clustering, Selection, Evaluation




Sector 1 Five Day Out Clustering Example












Comparison to SPDR S&P500 ETF

1 Hedge Fund Value Driven Portfolio (Shorting Allowed)

2 Mean/Sigma �Sharpe Inspired� Value Portfolio

3 Mean/Sigma^2 �Sharpe Sensitive� Value Portfolio




Comparison to SPDR S&P 500 ETF









Portfolio Annual Comp Ret Annualized Volatility Alpha Analytic VAR (5%) Sharpe

Hedge Fund 11.68% 11.31% 2.96% -4.28% 1.02

”µ/σ” 11.58% 12.76% 1.93% -4.88% .91

“µ/σ2” 11.56% 12.97% 1.77% -5% .89

Benchmark 9.86% 12.42% 0% -5.05% .8




Closing Thoughts

The Hedge Fund variant achieves higher returns through theability to engage in a wider range of �nancial activities(�shorting�)

There is a signi�cant disconnect between literature, �nancialpractice and legal responsibility

Theorists focus purely on return related to risk but not onother areas of suitabilityPractitioners focus on promotion but not on whether astrategy is fundamentally soundLawyers focus on suitability but not on the broader landscapeof �nance




Closing Thoughts

Many of the laws are poorly suited to deal with automatedtrading. Two possibilities

1 Politicians will amend the laws based on their understanding ofthe complexities of arti�cial trading, portfolio theory, and othernuanced ideas

2 The SEC will mostly wing it and tons of automated trading�rms will get sued during down years

It is worth thinking about the issues facing automated tradingnow as more �rms look to enter into this area and what mightbe considered reasonable regulations

It is also worth having larger discussions about whatregulations are reasonable for �nancial �rms and what rolethey should play in society


Documents

Arti cial Intelligence Systems and Investor Suitability ... · Seligman New echnologiesT Fund II, Inc., No-Action Letter, IM Ref. No. 20011019110 Set a precedent allowing hedge funds