Genetically Optimized Artificial Agents using various Strategies applied to Stocks

Trading

Forecasting Financial Markets 2003

Alexandre VIGIER

BNP PARIBAS Asset Management

alexandre.vigier@bnpparibas.com
avigier2001@yahoo.com

Abstract

This paper aims at presenting a portfolio construction process based on artificial agents which
use a limited number of, but radically different, investment strategies. Designed to replicate
simple investment rules well-known by fund managers or traders, the simulated agents adapt
themselves to the stock they have been assigned to. Viewed as stocks’ analyst, these agents
produce ratings or recommendations which are aggregated in order to construct a portfolio.

The kind of strategies come from two, somewhat opposite foundations : trend following
(channel breakout) and trend reversal. The first one consists in detecting a trend as soon as the
underlying price broke a channel defined by a moving average plus (or minus) a multiple of
standard deviation. The second one is exactly the contrary, as the signal triggered will assume
a mean reverting behaviour of the underlying time serie. Those two kind of strategies have
been studied in the past quite extensively, and many authors describe sometimes statistically
significant abnormal returns. As it can be assumed, the profitability of those strategies may be
closely related to various market conditions which use to be hard to detect properly.

In this study, we implement a methodology based on artificial technical agents which have the
ability to switch from one strategy to another, considering a utility function relying on their
relative short term profits. Considering this ability to consider various investment strategies,
we simulate nothing more than simple human behaviour (without irrational exuberance, such
as greed or fear) within a disciplined framework.

As the number of parameters for the two strategies and the switching mechanism is large, we
made use of genetic algorithm for each agent (stock) to derive a set of parameters during an
in-sample period. The profitability of this particular approach is analysed at the stock level
and considering a benchmark of the same stocks traded by our artificial agents. During this
exercise, we will test different assumptions about transactions costs to highlight the strategy
sensibility to trading frequency. Despite its simplicity, this methodology exhibited interesting
returns and risk/reward figures for a significant number of equities, during a large enough out
of sample period.

Keywords : Stock Selection, Active Portfolio Management, Genetic Algorithms, Multi Agents
Framework
Introduction

This is an attempt to build a portfolio construction process based on artificial agents which
use a limited number of, but radically different, investment strategies. Designed to replicate
simple investment rules well-known by fund managers or traders, the simulated agents adapt
themselves to the stock they have been assigned to. Viewed as stocks’ analyst, these agents
produce ratings or recommendations which are aggregated in order to construct a portfolio.

The strategies involved are :

- a trend following (channel breakout) strategy and
- a contrarian or trend reversal strategy

The first one consists in detecting a trend as soon as the underlying price broke a channel
defined by a moving average plus (or minus) a multiple of standard deviation. The second one
takes exactly opposite trades, as the signal triggered will assume a mean reverting behaviour
of the underlying time serie. Both of these strategies have been studied in the past quite
extensively, and many authors reported statistically significant abnormal returns, although
over different time horizons of investment.

I will introduce multi-agents framework and genetic algorithms in section 1. Then I will
describe the stock selection methodology in section 2 and will comment the results in section
3.
I - Multi-Agents Modelling and Genetic Algorithms

Multi Agents Framework

Distributed Artificial Intelligence is one of the various artificial intelligence techniques which,
as neural networks, fuzzy logic or genetic algorithms, has emerged with the achievement of
powerful calculations capabilities. For a thorough understanding of this field, one can refer to
Bond and Gasser (1988). Multi-agents frameworks have been widely used to solve complex
problems, such as planning, complex simulations in Nature sometimes linked to ethology, and
others.

Artificial agents frameworks began to be applied in the finance arena to mimetise investors or
to replicate observed behaviours, as Farmer Doyne (1999) relates in his paper.

Parkes David C., Bernardo A. Huberman (1997) describes an interesting methodology for
stock selection using various families of agents, either communicating or non communicating
ones, adaptative and non adaptative, leading to the conclusion that an evolved multi agent
framework can suit to the portfolio construction problem. Jefferies (2001) described an agent
based model which was able to perform better than random on real financial data.
Zimmermann et al (2001) showed how to integrate explanatory multi-agent models of
economic behaviour and an econometric framework into Neural Networks to model
simultaneously several Foreign Exchange Markets.

On a pure simulation point of view, we have seen in the past an inclination to model the real
world with complex differential equation and then, facing the gap between the model and the
reality, the research community tended to focus on a more microscopic understanding of the
phenomena.

I guess that we can obtain much more accurate models or simulation by focusing on this
microscopic level and by integrating the complex, sometimes irrational, behaviour we use to
observe in the finance community. By doing do, we well could be able to achieve a better
understanding of today’s financial markets. When we think about financial markets in terms
of distributed artificial intelligence, we could describe the traders and fund managers using
cognitive artificial agents, and the markets themselves as blackboards which materialize those
agents actions.

Genetic Algorithms

Defining another field of artificial intelligence techniques, Genetic algorithms (GA) find their
foundations in the evolution theory inspired by Darwin. First proposed by Holland (1975),
genetic algorithms belong to the family of population based optimization algorithms and
proved their ability in solving a number of hard problems, although suffering sometimes from
convergence speed.
Introduced by Cramer (1985) and developed by Koza (1992), Genetic programming represents
another branch of the genetic algorithms whose goal is to discover solution by incrementally
evolving the structure of the solution.

The underlying theory of genetic algorithms relies on mutation and crossover, applied to each
possible elements of the solution. The interest of this technique is to be able to explore the
whole space of solutions, and to always (when correctly parameterised) having elements
exploring other areas than optimal or local solutions. As the following figure is suggesting,
one may easily visualize the above mentioned ideas :

Figure 1 : Illustration of Genetic Algorithms search capabilities

During the optimization, genetic algorithm individuals tend to concentrate around the optimal
points, due to the elitist strategy which consists in conserving the best individuals from one
generation to another. But the other point is that this kind of algorithms will always to explore
the remaining solution space as the mutation and crossover mechanism generates new
individuals at each generation. Mutation is also of great help when an individual (part of the
genetic solution) is in a hole like the one in the above graph: a descent gradient algorithm
would be stay in this sub-optimal area, but, due to mutation, genetic algorithms are ensured to
generate a new individual from the bad one which will have a totally new score with respect to
the optimum searched.

In the recent past, various studies have been published which made use of genetic algorithms
or genetic programming to implement strategies whose goal is to outperform either Exchange
Rate or Equity Markets. Neely et al (1997) applied a genetic programming approach to derive
technical trading rules and found an out of sample outperformance over the US Dollar.
Karjalainen (1999) reported no significant outperformance for SP500 index. Dempster et al
(2001) found encouraging results as genetic algorithms outperformed other methods on an out
of sample set for intraday trading on the Foreign Exchange market, transaction costs included.

More and more, Genetic algorithms and Genetic Programming techniques are considered in
the financial area.
II - Stock Selection Methodology
In this study, we opted for a modelling in which each agent is affected to one given stock, thus
in charge to recommend a “buy” or “sell” on it. It differs from Vigier (2002) where each agent
were asked to rate the stock against all the other possible stocks within the investment
universe. The difference is in the fact that agents are here able to opt for different investment
strategy : a trend-following strategy or a contrarian, trend reversal strategy.

A large number of studies have been published about trend following or momentum strategies
and contrarian, sometimes called “Value” investment strategies. Quite often, authors reported
a significant added value or abnormal return investors could expect. The underlying
assumptions, from a fundamental point of view, suppose that investors may overreact or
underreact to certain information and that a well informed investor can benefit from these
extreme behaviours. If one agrees these assumptions, it is perfectly possible to create
abnormal returns from supposedly antagonist strategies such as value and momentum :
momentum driven strategies can outperform significantly over the short term and contrarian
strategies may do the same over a longer investment horizon. Indeed, these facts are reported
in Jegadeesh Natasimhan, Sheridan Titman (1993) and DeBondt Werner F. M., Richard
Thaler (1985, 1987).

Among these studies, Chan Louis K.C., Natasimhan Jegadeesh, Joseph Lakonishok (1999)
apply momentum investing for US Equities using both price momentum and earnings revision
momentum : the results exhibited from 1973 to 1993 and from 1994 to 1998 as an out of
sample set lead the authors to conclude on significant profits over 6 to 12 months horizon,
admitting a significant turnover. Dirk Schiereck, Merner De Bondt and Martin Weber (1999)
study momentum and contrarian strategies applied to the German equity market from 1961 to
1991 and conclude that both of them appear to beat a passive approach. Clifford S Asness.
(1997) examines the interaction of value and momentum strategies on US stocks from 1963 to
1994. The author finds that both strategies are effective, although negatively correlated, and
related to each other in some aspects. Charles Lee and Bhaskaran Swaminathan (2000) made
use of trading volume information in order to better characterise momentum strategies and
their corresponding meaning or power.

In this study, we implemented the two alternatives, embedded in one investment agent which
has the ability to switch from one strategy to the other. For sake of simplicity, the switching
mechanism has been made extremely basic : when we observe a stronger profitability for one
system we “switch” to this system, meaning that we only take in consideration the signal
coming from this system. A third alternative has been envisaged and the agents had the
possibility to switch to it. This alternative is called the “random alternative” and consists in
producing random signal each day. It will be interested to observe how many times agents
choose this third alternative.

The trend following strategy we considered consists in buying (selling) if the closing price of
a stock becomes higher (lower) than :

MedianLagTF + (-) TFMultiplier * StandardDeviationLagTF

where
 LagTF and TFMultiplier are two parameters which will be estimated by genetic
algorithms.

The contrarian strategy we considered consists in selling (buying) if the closing price of a
stock becomes higher (lower) than :

MedianLagTR + (-) TRMultiplier * StandardDeviationLagTR

where

LagTR and TRMultiplier are two parameters which will be estimated by genetic
algorithms.

This contrarian strategy only relies on price history, although a large number of studies use
fundamental data such as dividends or earnings.

Although very basic, It is worth noting that those two investment strategies have worked quite
well with some of the stocks of our universe, and that, from one stock to another, one strategy
may largely outperform the other, or alternate, as shown in the graphs below :

Volkswagen - Cumulative Profit of trend following and Contrarian Strategies

200.00%

150.00%

100.00%

50.00%

0.00%
0 6 1/ 1 7

0 6 3/1 9

06 /2 0

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7/

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/0

-50.00%
06

-100.00%

-150.00%

-200.00%

Trend Follower Contrarian

Fig. 2 : Profitability of trend following and contrarian strategies for Volkswagen equity stock
 BNP Paribas - Cumulative Profit of trend following and Contrarian Strategies
100.00%

80.00%

60.00%

40.00%

20.00%

0.00%
98

01
/ 0 97

97

97

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-80.00%

Trend Follower Contrarian

Fig. 3 : Profitability of trend following and contrarian strategies for BNP Paribas equity stock

As one can see, we can also observe a lack of profitability for the two strategies, as it is the
case for BNP Paribas equity stock.

The switching mechanism

The fact that the two strategies have not the same profitable periods is not so surprising : as
those two strategies tend to have antagonist behaviours, one will tend to work well as the
other tend to lose money. This is the critical element : if the two strategies are not correlated,
even on a short period of time, it has to be positive on an investor point of view, as we will try
from one strategy to the other.

In Bourgoin (1998), we opted for a switching mechanism based on a mix of statistical

measures and technical analysis. In this study, I opted for a most simple mechanism : the
cumulative performance over a given time horizon in the past. This time lag forms the fifth
parameter of each agents, and this parameter will also and be jointly estimated using genetic
algorithms.

In this study, the optimization function, or fitness function, is the terminal performance at the
end of the in sample period, which has been set to December 31st 2001.
Concerning the genetic algorithm, I opted for the following parameters :
- mutation rate : 5%
- Elitist Strategy
- GA stops if fitness function did not increased over the last 100 generations.

The parameter of each agent are estimated from January 1997 to December 31st 2001, and the
out of sample period starts from January 1st 2002 to December 31st 2002.

Portfolio Construction and other assumptions

We put ourselves in a benchmarked type of investment : the goal is to outperform a

benchmark, composed by an equal weighting of all the stocks of this benchmark.

In order to materialize the agents recommendation, when a stock receives a “Buy” signal, its
weights is set to twice its original weigth, and when the stock receives a “Sell” signal, its
weigth is cut by half, whether the corresponding signal comes from the trend-following side or
the contrarian side of the investment agent.

We considered a European investment universe, as defined by the Dow Jones Euro STOXX
50 index, composed by 50 stocks.

The trading costs have been set up to 20 basis points for the simulations presented in this
study.
III - Results

The parameters obtained at the end of the in sample period are worth the comment.
Whichever the parameter we consider, we can observe in the following figure that those
parameters may vary a lot from one stock to another, which is not surprising. We can also note
that we observe some stocks exhibiting close values, either for the lag parameters or the
multiplier or even the switcher lag.

Although not reported here, even in I observed a majority of outperfomance during the in
sample period, a few stocks exhibited an underperformance.
Lag for switching mecanism

Telefonica

Banco Santander

Repsol

Muenchener Ruekler

Bayerische Hypound Vereinsbank

France Telecom

E.ON AG

Endesa

Deutsche Bank

Carrefour

BBVA

Aventis

Ahold

T elecom Italia

Volkswagen
0 10 20 30 40 50 60 70 80

Fig. 4 : Lag estimated for the switching mechanism

Lag for Trend Following Mode

Telefonica

Banco Santander

Repsol

Muenchener Ruekler

Bayerische Hypound Vereinsbank

France Telecom

E.ON AG

Endesa

Deutsche Bank

Carrefour

BBVA

Aventis

Ahold

Telecom Italia

Volkswagen
0 20 40 60 80 100 120 140 160 180 200

Fig. 5 : Lag estimated for the switching mechanism

 Multiplier for Trend Following Mode

Telefonica

Banco Santander

Repsol

Muenchener Ruekler

Bayerische Hypound Vereinsbank

France Telecom

E.ON AG

Endesa

Deutsche Bank

Carrefour

BBVA

Aventis

Ahold

T elecom Italia

Volkswagen
0 5 10 15 20 25 30

Fig. 6 : Lag estimated for the trend following strategy

Lag for Contrarian Mode

Telefonica

Banco Santander

Repsol

Muenchener Ruekler

Bayerische Hypound Vereinsbank

France Telecom

E.ON AG

Endesa

Deutsche Bank

Carrefour

BBVA

Aventis

Ahold

Telecom Italia

Volkswagen
0 20 40 60 80 100 120 140 160 180 200

Fig. 7 : Lag estimated for the contrarian strategy

Multiplier for Contrarian Mode

Telefonica

Banco Santander

Repsol

Muenchener Ruekler

Bayerische Hypound Vereinsbank

France Telecom

E.ON AG

Endesa

Deutsche Bank

Carrefour

BBVA

Aventis

Ahold

T elecom Italia

Volkswagen
0 5 10 15 20 25 30

Fig. 8 : Lag estimated for the contrarian strategy

 May be the most interesting illustration is the relative preference for each of the three
strategies (included the random strategy) over time. In Figure 9 below, one can note that the
time spent by each agent in the random mode may become significant for some stocks. This
implies that the trend following and the contrarian strategies may reveals to be unprofitable,
leading to the conclusion that other type of investment strategies have to be implemented
instead of the ones considered.

Analysing Figure 9, we cannot conclude to an overall preference for the trend following
strategy or the contrarian strategy, excepted for a small number of stocks, like Volkswagen
equity stock for instance, where its agent spent almost 80 % of time preferring the contrarian
strategy.

Average System Preference (all period)

Suez

Sanofi Synthelabo

Royal Dutch Petroleum

L'Oreal

Societe Generale

Total Fina Elf

E.ON AG

Endesa

Deutsche Bank

Carrefour

BBVA

Aventis

Ahold

Telecom Italia

Volkswagen

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Trend Following Mode Contrarian Mode Random Mode

Figure 9 : Time spent by each agent using the available strategies

Figures 10 and 11 below represent the cumulative profit over the total period and the out of
sample period, for both the benchmark (the equally weighted investment universe) and the
active portfolio.
 31 02
/1 /0
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20

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Portfolio
15 02 /0 000
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Portfolio
7/ 02 5/2
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20 9
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8/

Index
20 02 1/ 2
26 02 /0 000
Index

/0 02 1/2
8/ /0 0 0
20 1
09 02 02 3/ 2
/0 /0 001
Figure 10 : Cumulative Return over the total period
9/ 02 5/2
20
23 02 /0 001
/0 7
9/ 0 2 /2

Figure 11 : Cumulative Return over the out of sample period

/0 001
07
20
02 0 2 /29
/1 /1 001
0/
20 02 1/ 2
21 02 /0 001
/1 0 2 1/2
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20 /0 0 0
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20 1/
02 20
02
We can observe a pretty good ability to minimize the drawdown during year 2002, which is
the out of sample period we considered, in spite of underperformance periods against the
index, for instance from the beginning of September to the end of October.

During the in sample period, the active portfolio appeared to exhibit an annualised excess
return of 5.7 % given an annualised tracking error of 10.1 %, resulting in an information ratio
of 0.56.

For the out of sample period, the same active portfolio exhibited an excess return of 15.1 %
for an annualised tracking error of 25.1 %, resulting in an information ratio of 0.60. Although
we were able to keep a positive excess return, we observe an large increase of the tracking
error, and this should stay under careful monitoring in the future.

Despite encouraging results, we have to keep in mind that, even accounting for transaction
costs of 20 basis points, the number of transactions is large, around one transaction every
week for each stock of the universe. Thus, the sensitivity to transaction costs and slippage is
critical for the positive achievement of the methodology and must be carefully monitored.
Conclusion

We have implemented a stock selection methodology in which artificial agents are able to
switch from various investment strategies. The strategies involved implies various parameters
which were estimated using genetic algorithm. Each agent, affected to one equity stock, was
able to choose between predefined trend following and contrarian investment strategies, and a
random strategy generating daily signals. We observed that, during the in sample period,
during which the genetic algorithms allowed us to estimate the five parameters of each agent,
the corresponding sets of parameters were very different from one agent to another. Besides,
the preference for each agent towards the trend following or the contrarian strategy could
strongly differ from one stock to another and, for some agents, the time spent preferring the
random strategy may be small but significant.

The resulting active portfolio exhibited encouraging results in terms of active return and
information ratio for an investment universe of 50 european stocks, but the transaction costs
and slippage are of critical importance due a large number of transactions.
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