Full replication in ETF and forex trading

 

Full replication and optimization. Both have pros and cons, so it can be challenging to decide which one is the best option for your specific needs. In this article, we will explore the differences between full replication and optimization so that you can make an informed decision about which one is right for you.

A novel strategy for trading Exchange Traded Funds (ETFs), called full replication. It is similar to the traditional ETF trading approach known as index-tracking. Still, it requires fewer stocks in each portfolio, resulting in a lower turnover of traded ETF units. Using data on the London Stock Exchange, we compare the performance of these strategies from January 2002 to December 2012. Under our benchmark assumptions, participants following an index-tracking strategy received 0.59% less gross returns per year than those following a full replication strategy on average over this period while incurring an additional 43 basis points of annualized transaction costs. In addition, participants following a full replication strategy had more stable portfolios with smaller maximum drawdowns and higher Sharpe ratios.

 

What exactly is full replication in trading?

Full replication refers to trading techniques whereby all orders placed by traders on their trading platform are executed in real-time and following market conditions, allowing traders to minimize risks and maximize gains. The forex industry relies heavily on retail traders. As such, it favours those who offer them automated solutions that enable them to trade efficiently and save costs that would have been used by human intervention. This has led to technological development over the years amongst brokerages offering different kinds of services within these few years. However, no other company can match IQOption’s Forex service for full replication, unlike brokers who offer this service but eventually do not always work in favour of the traders.

One of the most significant challenges in trading is when traders are unable to understand how their robot works, which almost always leads to poor performance and loss of funds. A demo trading account service offers a safe platform where forex robots can be tested without risking losing any real money; hence, the chance of losing lots of money is eliminated. Another advantage offered by demo trading accounts is that it allows you to practice your trading skills and test new robots before actually commencing with live trading. It helps traders who have just started or those who might want to trade on a long-term basis as demonstration mode does not require account holders to deposit funds into their accounts, making demo mode perfect for those who want to test robots thoroughly before applying them to their real accounts.

 

What is Forex replication?

Forex replication is when an order sent by a trader does not execute immediately on the market but enters a pending state pending execution in either a filled or unfilled status. This allows the trader to have time and space to cancel specific orders that may have adverse effects on the account, which can lead to more losses than gains.

When testing forex robots, traders often get into this situation whereby they set their robots/trading systems to send trades without ensuring that their accounts have the required capital to meet the margin requirement. When replication is enabled, this will ensure that when a trader sends an order which ends up in a pending state, they can cancel it at any time before it executes on the market.

 

 Is Full replication in trading safe?

We make it a habit of quoting the following famous words from Howard Marks in every issue of our newsletter: “In investing, what is comfortable is rarely profitable.”

With many investors on the sidelines and markets more correlated than ever before, making outsized returns has become virtually impossible for [most] active [funds]. As a result, we see increased efforts to improve risk management. Lower leverage and more cash positions may please some market critics who argue that too much money has been lost chasing performance in recent years. But it’s likely to disappoint many fund managers who have staked their careers in the pursuit of more significant returns.

What can investment managers do? Of late, there has been a proliferation of so-called alternative risk premia strategies that claim to protect capital and preserve returns under challenging markets. And while we would never be dismissive of any strategy’s attempt to reduce downside market exposure or create softer landings, we remain lukewarm on the subject for several reasons:

 

  1. We find it hard to take seriously any strategy claiming an ability to generate employment across major geographies and asset classes.

 

  1. To date, we have yet to see rigorous evidence demonstrating robust return predictability in the alternative risk premia space (e.g., low volatility, carry, trend-following, etc.). This is usually a function of limited history and concise time series. Unfortunately for investors trying to assess these strategies potential, it is often difficult to separate the signal from the noise.

 

  1. We find that most alternative risk premia strategies tend to rely on a combination of leverage and tactical position adjustment to juice returns. In most cases, such adjustments are not always successful in achieving their stated objectives due to unintended market reactions and poor initial positioning (e.g., getting long ‘low volatility right after an extended period of underperformance)

 

  1. Given all this, we believe it may be prudent for investors and managers alike to think about these strategies within a broader context: how does one’s exposure profile change with deteriorating macro conditions? This question cuts across time horizons and serves as a helpful lens to assess these strategies’ efficacy.