Portfolio123 Book. The General tab is where you lay out both a few identifying characteristics of the model and some basic assumptions.

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1 Portfolio123 Book Portfolio123 s book tool lets you design portfolios of portfolios. The page permits Ready 2 Go models, publicly available Portfolio123 portfolios and, at some membership levels, your own portfolio systems. Using these inputs, book lets you know what the correlations of those systems are, and what a holistic strategy would have yielded had you invested in it. As an executive summary, there are two things that you need to know about the tool before you can meaningfully use it: The correlations of a simulation are of the equity curve as a whole, and the results give no information on the holdings in the underlying portfolios; and the live book s recommended transactions are the result of the reconstitution of the live portfolios and the percentage rebalancing between assets. You therefore must rebalance your underlying portfolios before rebalancing the live book. The rest of this document is for those who are looking for more information. The tool is relatively straightforward to use. There are two modes: live book and simulated book. First, let s look at the simulator inputs. The General tab is where you lay out both a few identifying characteristics of the model and some basic assumptions. Book Simulation Name: The name of your model. This can be anything you want, but it must be unique in your account. The number of book simulations and live books that you re allowed to have is limited by your membership level. Category: The folder that this model will be saved within. Folders for simulations can be created by clicking on the Simulations link on the blue bar just below the top navigation. The left side of

2 the screen will then contain the user s folders, and the New button above the folders will create a new folder. Starting Capital: This is how much simulated cash the system will begin its backtesting with. The maximum amount is limited by your membership level. The default value of $100,000 is a good option for most people: There s enough capital to allow many positions, and the results are easily converted to a percentage return. Benchmark: This is the system s benchmark. In the resulting analysis, this will be the return that the system is compared to on the statistics and charting pages. Asset Rebalance Slippage: This is the percentage that will be lost to trading slippage whenever the assets are traded. The tool treats portfolio systems as assets to be balanced at set periods. Slippage, in this context, is how much is lost to trading costs or random stock price movements. Note that this figure is, perhaps, the most subjective number in this entire analysis. The underlying portfolios have their own slippage assumptions, but there is no allowance made for trades which are made simply to rebalance to the specified allocations of portfolios. That is what this field is meant to represent. Some double accounting is nearly unavoidable here. Asset Tolerance: This is the percentage that one of the assets must differ from its allocation in order to force a rebalance trade. Setting this to a higher number will reduce the number of trivial trades, while setting it to a lower number will result in a closer fit to the relative weights set on the next tab. Rebalance Frequency: This is how frequently the portfolio of portfolios should be reallocated. Note that this is independent of the rebalance frequency of the underlying portfolios. It is possible for a book to rebalance less frequently than its underlying portfolios. Visibility: This determines whether the book is available to the Portfolio123 community. Private hides the book and Public releases the book to everyone on the site. If you are a member of any groups, they will also appear here. If you select a group, the book will only be visible to members of that group.

3 The Assets tab is the meat of the Book tool. When you first open it, it appears to consist of a single button. That button is Add/Remove Assets. The only other feature of a newly created book simulation is the Reset link to its right, which does nothing yet. Pushing the Add/Remove Assets button brings up an interface to select assets. There are three possible things that can go into a book: Ready 2 Go models Public Portfolio123 portfolios and simulations Your own portfolios and simulations Subscribers at the Investor level are limited to only the first two, while higher level users may include their own models. Notice that there is no other limit to these portfolios: long, short, margin, and ETF portfolios are all just grist for the book. Note also that you need not be a current subscriber to a Ready 2 Go model to use it in simulation, though you ll need to subscribe to the R2G model if you want it in a live book.

4 On the left side of the resulting pop up is a set of folders that will correspond to available assets for inclusion. If you open a folder, you ll see portfolios within. Click on a portfolio will cause the right side of the pop up to fill with performance information. Selecting a new portfolio will update this performance information. Once a desired portfolio is selected, it can be added to the current book by clicking on the Add button. At this point, a powerful feature is unlocked: correlation.

5 If the book contains one or more assets then selecting a candidate portfolio from the left will not only update the performance information, it will also show the correlations of the selected portfolio with those assets already in the book at the top of the pop up s right side. Correlation indicates how in sync the movements of the assets equity curves are. This can be tremendously useful. In general, the less correlated two assets are, the more their risks will offset each other. This is the theory, of course. In practical terms, there are a few things to watch out for. First, while correlation trending toward zero is a good thing, a number that is very close to zero simply indicates that there is little correlation at all between the two assets. This is going to be rare on Portfolio123, which focuses almost exclusively on U.S. equities and ETFs. Nonetheless, it is possible that it could arise with some strategies that are intentionally looking for disparate performance and it s worth knowing. Second, the book tool analyzes the equity curves of whole portfolios without regard to their components. In particular, this means that it is quite possible that significant correlation can stem from common holdings. The book tool makes no attempt to discern this in simulation, though as we ll see, this can be clearly seen in the live book portion of the tool. Once all of the asset selections have been made, the user closes the pop up with the OK button

6 or discards the changes with the Cancel button. Assuming that the book now contains assets, the Assets tab itself now contains a correlation matrix below the list of assets. Next to each portfolio is a new box, the Relative Weight. Each of these boxes indicates how much of the total book each asset will represent. (The Reset link, by the way, will reset all of these weights to one.) The boxes are relative weights rather than percentages in order to facilitate adding and deleting assets during the analysis process. Percentages would require constant adjustment. To determine the percentage target of each asset, just total the relative values and then find the percentage contribution. For example, if there were three assets, each of weight one, each would contribute ⅓ of the total and the target percentage would be about 33%. If, on the other hand, there were three assets with relative weights two, one and one half, the asset weighted as a two would be approximately 57% of the portfolio, the one would be 29% and the one half would be 14%.

7 Having selected assets and weightings, just go to the Review tab. Note that unlike most tools on Portfolio123, users do not specify a timeframe for the simulation. The book simulation takes the maximum possible time frame in which all the assets exist as its period. At this point, the user hits the Run Simulation button (or the Get Recommendations button in a live book) and checks out the results page.

8 The book results page should look familiar to most users of the portfolio and simulation section. In general, the page is treating each of the input portfolios as a single asset in its analysis. Let s highlight some of the differences between a portfolio analysis and book analysis. First, notice that there is no turnover in a book simulation analysis. The analysis is done on a portfolio level. Turnover is very important for implementing a book strategy, and we ll see it return in the live book, but for the moment it s gone. Second, the holdings are just the current allocation to each asset. Again, this is a portfolio level analysis, and the book simulation gives no indication of what is actually in each portfolio at any given time.

9 Third, the Trading Statistics page is replaced with a Correlations Statistics page. The correlations page mimics the analysis that was already done prior to running the book simulation.

10 Finally, the Risk Statistics page has more columns. Note that there is one for the model as a whole and then there is one for each component asset. This difference bears a bit of consideration. If we may recommend: Never skip the risk statistics page in a book analysis. Quite simply, you should be looking for a book that improves upon the component portfolios in some way. This is the page where you ll be able to see whether it does. What does this mean? A book should be either safer or more profitable than any of its component portfolios. (It can be both, particularly when there is negative correlation as with long short systems.) If a book does not improve upon one of its underlying portfolios then you re just doing financial vandalism. One point to look at to see if this is the case is the Sharpe Ratio. That measure is a risk reward ratio. You want to increase the reward and decrease the risk, so if the Sharpe Ratio isn t budging, that s a problem. It s not the only place to look, though. For one thing, you can trend toward market neutral strategies, but if you decimate your returns it may be unacceptable. On the other hand, you may see that your returns have skyrocketed at the expense of desirable levels of risk. In either case, back to the drawing board by hitting the Rerun button at the top of the page. Now let us consider the live book portion of the tool. Let s look at the differences between the simulated book and the live book general tab. (The

11 Assets tab is exactly the same.) The Commission section simply reflects your cost structure with your brokerage. It works exactly the same as in the portfolio and screener sections of the site. Just enter your costs here. Slippage no longer reflects the theoretical asset slippage that we saw in the book simulation. This is the more concrete slippage that we see in the other tools. This is the slippage amount that will be applied to trades that are done simply to bring the relative weights of the underlying portfolios to their target weights. Note that there may still be double accounting depending upon the slippage assumptions of your underlying portfolios. As elsewhere on the site, the variable slippage option will impose a smaller slippage assumption to more liquid stocks than to more illiquid stocks, as shown in the following table. Finally, because a live book will generate trades of stocks generated by the underlying portfolio in proportion to the underlying portfolio, it will, even more than portfolios and screens, generate trades that can be trivial. The Minimum Rebalance Transaction box lets you set the minimum trade that will be shown to the user. This figure will not affect new positions or position liquidations. It only affects changes to holdings. Where should you set it? It defaults to $500, but your own transaction cost structure and rebalance frequency will dictate what this should be. Consider a multiple of your per transaction cost and then work out how comfortable you d be paying to make that adjustment. For example, would you be comfortable making a $20 transaction with a $10 commission? What about $100? $200? Rebalance Method gives the user the option of how they d like to treat future updates to the portfolio. No Rebalance means that the book will not update on its own; the user may still edit the holdings or the transactions directly. Automatic means that the book will update itself each rebalance period. Semi Automatic means that the book will generate a list of recommended transactions for the user to review and either modify or approve. Both the Semi Automatic and Automatic options will generate s alerts for the user. While there is no difference between the live book and simulated book assets screen, one major

12 criterion deserves emphasis: A live book can only contain live portfolios. It will appear to accept portfolio simulations, but the book will simply refuse to run. Having done our analysis and created a live portfolio, we are ready to hit the Get Recommendations button and get the holdings that will make up the book. If you have any of your own underlying portfolios that are not set to rebalance automatically, you need to rebalance them before getting book recommendations. It s important to know: The Get Recommendations button on the book page will not rebalance underlying portfolios. The book is not doing complex analysis; it s just telling you how your portfolios would work together. When a live book gives recommendations to the end user, it s just returning a portfolio made up of the individual components of the underlying assets in the proportion of the book s relative weights. The Get Recommendations button generates book trades based not only on changes to the underlying portfolios but also to the balance between the underlying assets. Imagine that you have two equal weighted assets in the book with a defined 2% difference tolerance. If they are at 53% and 47%, then the book will generate trades designed specifically to address that imbalance, subject to the restraint of the Minimum Rebalance Transaction box.

13 Having hit the Get Recommendations button, the user is now presented with a list of the recommended transactions. On the far right is a note that give the underlying asset that is responsible for the holding and the percentage of that underlying asset that the holding represents. If the holding is recommended by more than one asset, as with GPRE on line 11 in the above picture, then both will be shown. The user can either accept these recommendations as shown or reject them by clearing the

14 boxes. The Reset button will undo the user s input, returning the screen to the computer generated numbers. The Back button goes back to the asset allocation screen. The Commit button creates the portfolio. Because the live book is basically just a portfolio, the results pages of a live book are even more similar to those of a live portfolio than the book simulation. The holdings are now stocks rather than the underlying portfolios. And much like a portfolio s, the transaction page features the reason for a holding s purchase or sale. Note also the return of turnover statistics. (The chart and some statistics will be filled in as the portfolio ages.) Before wrapping up, let s look at what a rebalance will look like on a live portfolio.

15 There is only one input, a duplication of the Minimum Rebalance Transaction box. This means that you can override each rebalance, perhaps dispensing with trivial trades except for a once a year full rebalance. In summary, remember the following things and the book will be a useful tool for most users: 1. If you are using your own portfolios, remember to rebalance them before rebalancing your books. 2. Live books require live portfolios. 3. Book simulations give no information on the similarity of the holdings of the underlying portfolios. 4. If you re getting too many trades in a live book, try increasing the minimum rebalance transaction. 5. Compared to the underlying portfolios, always try to get better risk, better returns or both with your book. If not, just use the underlying portfolio.