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| Oct 20, 2023
Embark on a transformative journey from dot-com bubble losses to pairs trading triumph. Explore our path through financial turmoil, the art of pairs trading, and insights on xstocks.us, a platform that empowers users to create and test investment strategies. Discover how we harnessed AI technology for informed decision-making in the dynamic world of finance.
Our journey into the world of investments began during a period of immense market turbulence in the mid-20s, coinciding with the notorious dot-com bubble. It was a time of uncertainty, and we saw a silver lining in a 20% drop in stock prices, a perception that prompted us to dive into the world of technology stocks. Names like Nortel Networks, Purchase Pro, Nextel, Ariba, and Commerce One lured us in. Little did we know that some of these companies were entangled in the bubble, while others were tainted by fraudulent activities. One striking example was the CEO of Purchase Pro, reveling in Las Vegas while the company was in turmoil. Nortel Networks, once a titan, was soon to be brought to its knees, taking our $10K investment down to $3K in a mere four years.
This early experience was a wake-up call, leading us to seek knowledge in the world of finance. Enrolling in an MBA program and immersing ourselves in Stochastic Calculus and Investment Analysis classes, we delved into the world of efficient markets and the no arbitrage theory. These courses underscored the concept that in an efficient market, arbitrage opportunities are virtually non-existent. This knowledge left us pondering a crucial question: How can one generate profit without exploiting arbitrage?
The world of finance we were introduced to was anchored in the efficient frontier, a construct where all assets, from risk-free to high-risk, formed a neat parabolic curve. While the mathematics was elegant and easy to represent in a spreadsheet, something seemed amiss. The thriving hedge fund industry and the rise and fall of Long-Term Capital Management (LTCM) raised questions about the validity of this fundamental theory.
As we ventured deeper into the financial world, we stumbled upon a friend who introduced us to pairs trading, a concept that would later gain fame as statistical arbitrage. Our journey into pairs trading began with Indian equities, a relatively manageable domain due to the limited number of stocks with derivatives trading. Pairs trading allowed us to buy one stock while simultaneously selling another, acting as a hedge against market volatility. The apprehension regarding shorting stocks soon waned as we realized its necessity for portfolio protection.
In the competitive landscape of financial markets, self-interest became our guiding principle. We embraced the notion that market participants primarily seek their own interests, an inherent characteristic of asymmetrical markets. With this newfound perspective, we focused solely on our interests, a strategy we believed others in the market had already mastered.
Motivated by the potential of pairs trading, we expanded our algorithm to encompass the entire US stock market. Accessing data for this endeavor was relatively straightforward, thanks to Yahoo's provision of free end-of-day adjusted data. Armed with software like Eviews and a profound understanding of co-integration, our journey into statistical arbitrage took a decisive leap forward.
Market-neutral trading became our preferred strategy, offering minimal risk and a pathway to pure alpha generation. It was akin to flying a plane on autopilot, where we monitored entry and exit points, adhering to predefined rules. The tranquility it provided was well worth the occasional challenges when pairs didn't align as expected.
The year 2008 brought with it a financial crisis that shook markets worldwide. In response, we made the prudent decision to exit our long-only equity positions within our 401K accounts. We viewed the constraints imposed on 401K accounts as a mechanism controlled by politicians and the mutual funds industry to gain control of investors' assets. After significant effort, we had amassed $25K to initiate our pairs trading strategy, only to discover that executing it within a 401K account was hindered by SEC regulations.
Despite initial success in shorting REITs and credit card companies, our fortunes took a turn when the Federal Reserve initiated quantitative easing, purchasing longer-duration mortgages and treasuries. The consequences of this policy, including a notable surge in stock market performance, caught us off guard. From March 8th, 2009 onward, there was no looking back, as stocks embarked on a remarkable rally. Consequently, we fully transitioned into pairs trading, which consistently generated significant alpha. In just a year and a half, our portfolio delivered an impressive 32% return.
This success inspired us to create Liquidstrats, a platform where we shared our trades and allowed others to explore additional pairs. Unfortunately, due to personal reasons, we had to halt our trading activities and discontinue the website.
Simultaneously, India grappled with insolvency and widespread government corruption. The central bank's decision to raise interest rates by nearly 350 basis points over a period of just one year had a significant negative impact. However, this challenging environment presented us with an opportunity: investing in long-duration Indian bonds. We saw that the problems were blown out of proportion, and the CAD was manageable with proper governance. We turned our focus to 10-year and 15-year bonds, which had durations of 7–13 years. These bonds promised substantial returns if interest rates dropped by a mere 100 basis points, marking the beginning of our foray into macro plays. We added to our positions all the way till mid 2014, to reap good benefits until 2018 at which point we closed our positions for the next venture. This approach emphasized the importance of patience and understanding the macroeconomic landscape.
Next successful investment strategy revolved around Infrastructure Investment Trusts (InvITs) in India. These instruments, relatively unknown at the time, combined the characteristics of equities with the features of fixed income products. Some InvITs acted as long-duration funds with built-in inflation protection, offering attractive yields ranging from 14–18%. Recognizing this opportunity, we decided to sell a previously underperforming apartment in Hyderabad. We invested 60% of the proceeds in IndiGrid and the remaining portion in IRBINVT. This strategic move resulted in an impressive 22% CAGR in just three years. They continue to generate good dividends in the 10-12% range even today with minimal impact on our capital.
Throughout these ventures, patience and alignment with prevailing macroeconomic trends have proven to be paramount. While US interest rates are presently on an upward trajectory, the window of opportunity for long-duration bond investments has not yet opened. In the meantime, we diligently earn returns from short-duration bonds, poised to seize the awaited opportunities when they finally manifest. During this interim period, we embarked on the creation of www.xstocks.us, a platform that empowers users to devise their own straightforward investment strategies using our simple to use stock screener and instantly put them to the test. Additionally, we harnessed the power of AI to build what we lovingly call as Luna who would assist users in interpreting fundamental, technical, and other market-related data. This enables them to swiftly evaluate any of the 12,000+ stocks traded in India and the US, facilitating informed buy or sell decisions.
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