Note: Descriptions are shown in the official language in which they were submitted.
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APPARATUS AND ACCOMPANYING METHODS FOR
AUTOMATICALLY MODIFYING A FINANCIAL PORTFOLIO
THROUGH DYNAMIC RE-WEIGHTING BASED ON A
NON-CONSTANT FUNCTION OF
CURRENT CAPITALIZATION WEIGHTS
p
CLAIM TO PRIORITY
This application claims the benefit of
priority under 35 USC 119 to my previously tiled and
co-pending United States provisional patent
applications: one filed December 15, 1995 and assigned
serial number 60/008,698, and another filed July 3,
1996 and assigned serial number 60/021,116 and both
entitled "Automated Investment Portfolio Construction".
BACKGROUND OF THE DISCLOSURE
1. Field of the Invention
The invention relates to apparatus and
methods for automatically modifying a financial
portfolio having a pre-defined universe of securities,
that tracks a given capitalization weighted index,
through dynamic re-weighting of a position held in each
such security, wherein a current weight accorded to
each such security, relative to others in the
portfolio, is proportional to a non-constant function
of current capitalization weights of the securities in
the index. The invention is particularly, though not
."
exclusively suited, for use in managing an index fund
composed of a pre-defined set of equity securities.
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2. Description of the Prior Art
Currently and for the foreseeable future, tax
exempt funds, such as pension fund portfolios, hold a
5substantial, and continually and significantly
increasing amount of money diversified across various
forms of investments. At the moment, tax exempt funds
are estimated to have in excess of US $ 4 Trillion in
equity assets under management of one sort or another.
Of these assets, so-called "index funds" constitute one
popular investment vehicle that is often used in
pension fund management and currently account for
approximately US $ 600 Billion thereof. Index funds
are characterized by investing in all those securities
that collectively form a pre-defined index, such as,
e.g., all the different securities in the Standard &
Poor's (S & P) 500 or the Russell 1000 for US equities,
or in the TOPIX for Japanese equities. The
attractiveness of these funds lies in their ability to
generate a financial return that should track that of
the corresponding indices at low cost.
Generally speaking, an index is defined by a
pre-determined universe of issues which constitute that
index, e.g. common stocks of 500 large corporations
which trade on United States exchanges constitute the
S& P 500, as well as a proportion of the index, i.e. in
terms of a weighting, attributable to each different
issue therein. Illustratively, the weighting for each
30-different security in the S & P 500 index is simply the
market capitalization of that security expressed as a
percentage of the total market capitalization taken
across all the securities then in the index. Of
course, these weights continually change as share
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prices move which, in turn, changes market
capitalization both of each individual security in the
index as well as that across the entire index. Other
indices, such as the Value Line index, assign
different, e.g. equal, weightings to each security
therein.
Index funds generally fall into two distinct
categories: passive funds and enhanced funds. Passive
and enhanced index funds are distinguished by their
adherence, or lack thereof, to the security weightings
set forth in whatever index each such fund follows.
Specifically, a passive index fund merely
reflects a corresponding index of interest.
Specifically, a passive index fund manager will spread
total fund assets across every security in the index
and, for each such security, in a proportion set by the
proprietor of the index, hence identically reflecting
and continually tracking, to the extent possible, the
performance and composition of the index. For example,
a passive S & P 500 index fund manager will invest fund
assets across every one of the 500 common stocks that
forms the S & P 500 index and with a weighting given by
this index. As the index weightings change, typically
on a daily, weekly or other regular basis, positions in
the individual securities in the portfolio will either
be reduced or enlarged whenever necessary to accurately
reflect these changes. In addition, should a given
security be eliminated from the index, as a result of
e.g. insufficient market capitalization or bankruptcy
of its issuer or merger of its issuer into another
entity, or alternatively a new security be added to the
index, due to the increased capitalization of its
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issuer, the fund manager will then appropriately sell
or buy that security to mirror the composure and
weightings then existent in the index. Of the $ 4
Trillion currently invested in tax exempt funds,
5- approximately $ 600 Billion of that amount is invested
in passive index funds.
In sharp contrast, an enhanced index fund
contains positions in the securities that constitute a
10- corresponding index of interest but the fund manager
thereof replaces the passive index weighting by
his(her) own weightings for each security. Risk is
controlled here inasmuch as an enhanced index fund
manager usually monitors a so-called "tracking error"
15 that measures a difference between whatever financial
return he(she) receives relative to that of the
underlying index itself, e.g. the return of S & P 500
index for an enhanced S & P 500 index fund, and trades
in a fashion that maintains this error within
20 acceptable bounds. Enhanced index funds hold
approximately $ 75 Billion of tax exempt assets under
management.
Historically speaking, index funds are rooted
25 in a "Capital Asset Pricing Model". For further
details thereon, the reader is referred to W. Sharpe,
°'Capital asset prices: a theory of market equilibrium
under conditions of risk", Journal of Finance, Vol. 19,
1964, pages 425-442. In accordance with this model,
30 under ideal conditions, an investor in a market, ,
seeking to maximize his expected return at a given
level of risk, will hold a combination of cash and
every stock available in that market, with the
weighting of each such stock being proportional to its
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current capitalization weighting in the market.
Underlying this model are two basic assumptions: (a)
all investors are said to possess the same knowledge,
i.e. information, and outlook, i.e. expectation, on
"' 5 each stock, and (b) each investor can borrow an
unlimited amount of money at the US treasury bill rate.
While both of these assumptions are obviously widely
fallacious, index funds actually perform rather well
over a reasonable period of time.
In that regard, for a moderate investment
horizon of 3-5 years, index funds have proven to be
attractive investment vehicles for the simple reason
that these funds, ignoring their management fees but
including their transaction costs, tended to perform
better, i.e. have regularly generated a greater annual
return with no greater risk, over this period than have
most financial money managers who actively pick
individual securities for investment. This effect is
particularly true where substantial pension assets,
such as several billion dollars are to be invested.
Given that most fund managers tend to
under-perform various market indices, such as the S & P
500 index, pension plans are increasingly turning to
index funds as one part of a multi-faceted strategy
aimed at obtaining an increased investment return at an
acceptable risk.
By their very nature, enhanced index funds
require far more active and sophisticated management
than do passive index funds. Security selection and
weighting decisions are often the product of a highly
sophisticated, continuous and complex analysis and
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decision-making process which is rather difficult and
quite costly to implement and then execute on a routine
basis -- particularly considering the need for
effective and close human supervision and intervention.
Consequently, management fees on enhanced index funds
typically amount to 30-50 or more basis points (a basis
point being .01~ -- hereinafter simply ''bp'°) of the
assets of the fund against generally 5-15 by for a
passive index fund. While passive index funds tend to
just mirror the return of the underlying index,
enhanced index funds, because of their higher cost
structures, strive to consistently outperform the index
typically by .5$ - 2~ per year in order to attract
sufficient levels of fresh investment capital and then
retain it.
Unfortunately, in practice, enhanced index
funds, due to the complexities of the attendant
analysis and decision-making and the monetary costs
thereof, have experienced considerable difficulty in
achieving the level of return necessary to attract
substantial amounts of new capital over that directed
to passive index funds -- though no theoretical
impediment to achieving such a return for an index fund
appears to exist.
Given the inherent diversification, an index
fund with objective simplicity, low costs, fees
comparable to a passive index, and which produces a
return to its investors consistently exceeding that of
a major index, such as the S & P 500 index, by as
little as, e.g., 40 by per year, may attract _
significantly increasing pension fund investment. Thus
far, such a fund does not exist.
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Furthermore, over the past few decades,
various securities exchanges, such as the New York
Stock Exchange (NYSE), have instituted a variety of
electronic and computerized networks to rapidly handle
substantially increasing trading volumes, particularly
from institutional traders. These systems, typified by
the NYSE Direct Order Turnaround (Super DOT) system,
provide mechanisms for high-volume, reduced cost
electronic trading. While the NYSE possesses a trading
floor manned by human trading specialists-through which
all NYSE trades ultimately pass, another exchange, i.e.
the NASDAQ (frequently referred to as the over-the-
counter (OTC) market) is solely electronic in nature.
In contrast with the NYSE, the NASDAQ consists of an
electronic network interconnecting, e.g., financial
institutions and other exchange members, and various
'redundant server computers, connected-to the network.
Trading orders are electronically directed from
- workstations and internal networks situated at NASDAQ
exchange members, through the NASDAQ network to and are
ultimately executed by the NASDAQ servers, which, upon
each trade execution, returns an appropriate
confirmation, via the NASDAQ network, to the associated
exchange members. In addition to the electronic
trading mediums provided by various exchanges,
financial institutions have adopted their otr~n computer
based trading networks, e.g. so-called "crossing
networks", that interface not only with those of the
exchanges at which trades will be executed but also
with those of other such institutions far off-exchange
trading. Trading orders can also be posted by computer
to various electronic bulletin boards which are
regularly downloaded by financial institutions to
solicit their interest and bid in any of these orders.
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Moreover, financial information, particularly
securities pricing, is being increasingly disseminated
across an exceedingly wide geographic area in real-time
electronic form. For example, this information can be
obtained from, e.g.. a satellite feed: a terrestrial
broadcast such as teletext or other data inserted into
a broadcast television signal; data inserted into a
broadcast radio signal; a dedicated computer linkage
connected through the Internet or a private network to
an appropriate server; or even a dial-up modem
connection, established between a personal computer
executing a suitable communication and/or financial
program or through a dedicated terminal, and, via a
publicly switched telephone network, a distant server.
In order to cost-effectively manage an index
fund, real-time security price information, from
whatever source is chosen, generally needs to be
electronically downloaded and electronically processed
with resulting trading orders then being sent, via one
or more electronic avenues, for appropriate execution.
Hence, a need exists in the art for apparatus
and accompanying methods that, with only a modest
amount of human oversight, will effectively manage a
portfolio, particularly an index fund, in a manner
which is likely to consistently yield a return which
sufficiently exceeds that provided by a typical passive
index fund but without the complexities and costs
typically associated with an enhanced index fund.
r
Advantageously, such apparatus and methods should
implement an investment vehicle which yields a return ,
that is sufficient to garner an appreciable amount of
investment capital that would otherwise flow to passive
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index funds. In doing so, this apparatus must operate
as cost-effectively as possible by: (a) utilizing
' market information in electronic form, (b} processing
this information electronically to generate appropriate
trading orders, and (c} seamlessly integrating into the
various computerized financial networks to utilize
computer-based order placement and/or execution, where
appropriate.
SUMMARY OF THE INVENTION
Advantageously, my present invention
substantially, if not totally, remedies the
deficiencies inherent in the art. Specifically, I have
broadly recognized that, for a portfolio, such as an
index fund, that holds a pre-defined universe of
securities which collectively forms a capitalization
weighted index, the portfolio can be effectively
managed by dynamically re-weighting the position of
each security in the portfolio in a manner proportional
to a non-constant function of current capitalization
weights of the securities in the index. I have found
that, for appropriately selected functions, the
resultant return generated by such a portfolio will
consistently and reliably outperform that of the index
itself.
Specifically, my inventive apparatus contains
circuitry which obtains appropriate input information
and an appropriately programmed computer system. The
input information, which can be provided from any of a
' wide variety of sources, includes an enumeration of
each security in the index and its shares currently
outstanding, as well as current price information on
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each such security and its price change. The computer
system, using this information as well as internally
stored portfolio data, first determines a variable
("target") weighting for each of the securities in the
portfolio as the non-constant function of current
capitalization weights associated with the index, so as
to define a set of target weights. Once all the target
weights have been so determined, the computer then
issues digital trading instructions, each of which
represents a trade of a corresponding security, to,
e.g., an electronic trading network such that current
assets held in the portfolio are to be distributed,
upon subsequent execution of the instructions, amongst
the securities in the portfolio in proportion to and as
defined by the target weights so as to dynamically
rebalance the portfolio. This inventive portfolio
rebalancing method is periodically repeated, such as
weekly, daily or at any other such desired interval,
to: analyze current changes in share price and current
index composition and weightings, calculate new
positions in each security held in the portfolio and
issue appropriate market trade orders to appropriately
update, i.e. rebalance, the portfolio holdings to
reflect these new positions. As any particular
security is deleted from or added to the index, the
portfolio, through my inventive dynamic rebalancing
process, reflects that deletion, i.e. through
liquidation of any holdings in that security, or the
addition, i.e. by calculating a target weighting for
that security and establishing a holding therein once
this target weighting reaches a sufficient, though,
e.g., relatively low, level.
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As a feature, my inventive apparatus,
particularly the computer system therein, can assume
either of two pre--defined operating modes: a
rebalancing mode and a "cash investment" mode. Through
the rebalancing mode, weights of each security in the
portfolio are re-calculated and the portfolio holdings
dynamically rebalanced with resulting issuance of
appropriate market orders. Through the cash investment
mode, transactions, e.g. security purchases, are
successively generated, to the extent necessary, to
consume excess cash (e.g. large cash inflows) in the
portfolio that may have arisen as a result of recent
dividend payments) and/or security sales that occurred
due to deletion from the index. Through use of the
cash investment mode, a cash balance in the portfolio
remains within a relatively small pre-defined range
with the remaining assets in the portfalio being
invested in securities.
As a further feature, my inventive apparatus
permits a user to proscribe, for whatever reason, any
security in the index from being traded in the
portfolio. As a result, portfolio assets will be
allocated to and dynamically rebalanced among the
remaining securities currently in the index, i.e. those
for which trading is permitted.
BRIEF DESCRIPTION OF THE DRAWINGS
The teachings of the present invention can be
readily understood by considering the following
detailed description in conjunction with the
accompanying drawings, in which:
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FIG. 1 depicts the correct alignment of the
drawing sheets for FIGS. lA-1D;
FIGS. 1A-1D collectively depict large scale,
though simplified, security trading system 5
incorporating my inventive dynamic portfolio management
system 65;
FIG. 2 depicts a high-level block diagram of
the hardware components implementing computer system 50
and particularly trade generating computer 60 therein,
as shown in FIGs. lA-1D;
FIG. 3 depicts a high-level block diagram of
the software resident within memory 240 and executing
within trade generating computer 60, both shown in
FIG. 2;
FIG. 4 depicts process diagram 400, which
shows various high-level operations that, within the
context of system 5 shown in FIGS. lA-1D, collectively
implement my present invention;
FIG. 5 depicts definitions of various
variables used in conjunction with my inventive Dynamic
Portfolio Management Program 330 shown in FIG. 3;
FIG. 6 depicts the correct alignment of the
drawing sheets for FIGs. 6A-6C;
FIGS. 6A-6C collectively depict a high-level
flowchart of my Main Program 600 of Dynamic Portfolio
Management Program 330, shown in FIG. 3, that is
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executed within trade generating computer 60, shown in
FIG. 2;
FIG. 7 depicts the correct alignment of the
drawing sheets for FIGS. 7A and 7B:
FIGs. 7A and 7B collectively depict a
flowchart of Target Proportion Determination
routine 700 that is executed by Main Program 600 shown
in FIGS. 6A-6C~
FTG. 8 depicts a flowchart of Current
Proportion Determination routine 800 that is also
executed by Main Program 600 shown in FIGS. 6A-6C;
FIG. 9 depicts the correct alignment of the
drawing sheets for FIGS. 9A and 9B;
FIGs. 9A and 9B collectively depict a
flowchart of Trade Determination routine 900 that is
executed by Main Program 600 shown in FIGs. 6A-6C;
FIG. 10 depicts the correct alignment of the
drawing sheets for FIGs. 10A and lOB;
FIGS. l0A and lOB collectively depict a
flowchart of Cash Control routine 1000 that is executed
by Main Program 600 shown in FIGS. 6A-6C;
FIG. 11 depicts table 1100 which provides,
for purposes of comparison, abbreviated S & P 500 data
and simulated corresponding numerical data, the latter
generated through use of my present invention using
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S & P 500 data at two exemplary successive weekly
dates;
FIG. 12 depicts, in graphical form, simulated
performance data for my present invention, along with
actual performance data for the S & P 500 and
Russell 1000 indices for the period 1979-1995; and
FIG. 13 depicts, in tabular form, annualized
simulated performance data for my present invention,
along with annualized actual performance data for the
S & P 500 and Russell 1000 indices for the period
1979-1995.
To facilitate understanding, identical
reference numerals have been used, where possible, to
designate identical elements that are common to two or
more of the figures.
DETAINED DESCRIPTION
After considering the following description,
those skilled in the art will clearly realize that the
teachings of my invention can be readily utilized to
manage an index fund based on any capitalization
weighted equity index -- whether national or
international in nature. Through use of my inventive
teachings, weights of each individual security in that
fund is determined as being proportional to a
non-constant function of current market capitalization ,
weights of all the individual securities that form the
index. Examples of capitalization weighted indices, on ,
a national basis, are the Standard & Poor's (S & P)
500, the Russell 1000, the TOPIX in Japan, the
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Financial Times Stock Exchange 100 (FTSE) in the United
Kingdom and the DAX index in Germany, and on an
international basis, the Morgan Stanley Capital
International (MSCI) EAFE (Europe, Australia, Far East)
index. To simplify the following discussion and
facilitate reader understanding, I will describe my
present invention in the context of use with
illustratively the S & P 500 index. In addition, since
my invention can effectively manage not only shares of
common stock in an index fund but also any,financial
instrument that has a value related to common stock,
such as, e.g., derivatives, options, swaps, futures
and/or any combination thereof, the term "security" as
used hereinafter is defined to collectively encompass
common stock and any such financial instrument.
A. Hardware Hierarchy -
A large scale, though simplified, security
trading system 5 incorporating my inventive dynamic
portfolio management system 65 is collectively depicted
in FIGs. 1A-1D; the correct alignment of the drawing
sheets for these figures is depicted in FIG. 1. My
inventive management system can readily function to
manage a portfolio of securities on any exchanges) and
even a portfolio that extends over multiple_exchanges,
e.g., securities on the S & P 500 index can be found on
the New York Stock Exchange (NYSE), NASDAQ and American
exchanges. To simplify the figures and the ensuing
discussion, I will illustrate and discuss my invention
in the .context of use with securities traded on the
NYSE.
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Within system 5, Dynamic Portfolio Management
system 65 manages an index fund in accordance with my
inventive teachings. System 65 executes within trade
generating trade generating computer 60 located within
computer system 50, which is situated at, e.g., a
central site. Computer 60 receives input information
from a number of sources and, through my inventive
management process implemented in software and
discussed in considerable detail below in conjunction
with FIGS. 5-10B, generates trade orders as a result to
electronic trading network 3. This network provides a
number of avenues through which trades can be executed.
As used hereinafter, a °'trade order" is defined to be a
combined list of buy and sell orders for a number of
securities. For execution, such an order is parsed
into a "trade", either a buy or sell, of each
individual security in the order.
As input, system 65 obtains share prices,
share price changes and S & P 500 information,
specifically those securities that form the S & P 500
index and their shares outstanding. Current share
prices and changes in these prices are obtained from,
e.g., a terrestrially broadcast satellite distributed
service. In that regard, satellite receiver 20, via
satellite antenna 7, receives appropriate broadcast
(transmitted) signals, demodulates the received
signals, extracts the received data therefrom and
converts the data into a serial digital data stream.
This stream is directly applied, via line 12, to an
input of trade generating computer 60. Of course, this
market information can be obtained, via transmission,
from a wide variety of other sources, such as a
terrestrial broadcast such as teletext or other data
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inserted into a broadcast television signal; data
inserted into a broadcast radio signal; a dedicated
' computer linkage connected through the Internet or a
private network to an appropriate server; or even a
" 5 dial-up modem connection, established between trade
generating computer 60, and, via publicly switched
telephone network (PSTN) 40, a distant server (not
specifically shown). In addition, computer 60 accesses
S & P 500 information by establishing a modem link, via
telephone line 66, through PSTN 40 and telephone
line 16, to S & P information server 15 (which is
typically a networked data server). In response to a
query from computer 60, S & P information server 15
transmits, as another digital data stream, current
S & P 500 information, specifically the constituent
securities that currently form the S & P 500 index
along with a current number of shares outstanding for
each such security. In the event of a failure in,
e.g., antenna 7 or receiver 10, current share price and
price change data can alternatively be obtained through
a modem connection established, via PSTN 40 and
telephone lines 66 and 27, between computer 60 and
remote site 20. This site contains satellite
antenna 22 which feeds satellite receiver 24, both of
which are either identical or sufficiently similar to
antenna 7 and receiver 10, to provide the same digital
data stream that would appear on lead 12. The output
of receiver 24 is applied to remote server 26 for
packetization and communication, over PSTN 40, to
computer 60. PSTN 40, though shown as three distinct
network entities in FIGS. lA-1D to simplify
understanding, is actually a single unitary network.
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Though specific input modalities have been
described above, input data can be supplied to
computer 60 in any electronic form or in any other form
that through appropriate circuitry is converted into
suitable digital form for use by computer 60, this
circuitry which could include, e.g., a computer input
device such as a keyboard and/or mouse (as shown in,
e.g., FIG. 2 and discussed below} would be converted to
this computer.
As discussed below, computer 60 internally
stores current information regarding the portfolios)
being managed, its cash position and appropriate
parameter values. Once all the required input
information is received, inventive management
system 65, in the inventive manner discussed in detail
below, iterates through all the securities in the S & P
500 index to calculate a new weighting, as a percentage
of the portfolio, of that security.
Apart from computer 60, computer system 50
also contains accounting computer 80 and trade
execution computer (server) 70, both of which are
interconnected, with computer 60 through local area
network (LAN) 77.
Each resulting trade order, generated by
system 65, is analyzed to determine, based on, inter
alia, the size of the trade, the most cost-effective
and suitable avenue through which the trade order can
be executed. These avenues include: posting, as agency
trades, on an electronic bulletin board for accessing
and execution by a selected broker: through the NYSE
Super DOT (Direct Order Turnaround) system; direct
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placement, as a principal trade with a broker; through
a crossing network for off-exchange trading through
"° various automated trading systems, such as "Instanet"
and "POSIT" systems. Other than off-exchange trading,
all other on-exchange trades involving NYSE securities
pass through the NYSE and as such are ultimately
routed, via a broker in the first instance - typically
by an order execution system therein, to a
corresponding human being, i.e. a so-called "floor
specialist" on the exchange.
In particular, once system 65 generates a
list of trades to be made, computer 60, through
execution of appropriate conventional software, prints
a list of appropriate trade orders as a so-called
"trade sheet". These trades are also transmitted, as a
file and via LAN 77, to computer 70. A human trading
analyst, interacting with computer 70, analyzes each
proposed trade generated by system 65, both to detect
and prevent any clearly erroneous trade orders from
being placed for execution as well as to properly place
correct trade orders with appropriate trading avenues
available through electronic trading network 3. Once
this analyst has selected an appropriate avenue for
each such order and has signified his(her) selection to
trade execution computer 70, this computer then
appropriately formats the trade order to the match
input requirements of the selected avenue and then
transmits the formatted trade order to that avenue for
subsequent execution.
Trade generating computer 70 maintains
electronic bulletin board 75, which is conventional in
nature, to which trade orders can be posted as so-
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called "agency trades" and subsequently accessed by a
broker designated by the analyst. Each broker, that
can be designated as an agent broker, is assigned a
different page on the bulletin board through which that
broker can down-load and up-load files from and to the
bulletin board. Should the analyst select the °'agency
trade" avenue for any given trade order, computer 70
merely posts a computer file containing that trade
order onto the bulletin board for the particular broker
designated by the agent and specifically onto the page
for that particular broker. This designated broker,
through its order execution system, can establish a
telephonic connection to the computer 70 and download
the order file, from its page on the bulletin board,
for subsequent execution. Specifically, each broker,
that can be designated as an agent broker, has a
computer based order execution system, which are
collectively depicted as order execution systems 130
formed of individual order execution systems 1301 for
firm 1, 1302 for firm 2, ... 130m for firm m. Each of
these order execution systems, either under manual
instruction or automatically, can establish a modem
connection, via lines 135 (formed of lines 1351, 1352,
..., 135m connecting execution systems 1301, 1302, ...,
130m, respectively), via PSTN 40 and telephone line 78,
to trade execution computer 70. Through this modem
connection, any of these or more of these brokerage
firms can download any trade order file that has been
posted to its page on the electronic bulletin board 75.
Once such a file has been downloaded into the
appropriate order execution system at the designated
brokerage firm, the order is suitably executed. Once
the designated brokerage firm has executed a trade
order, that brokerage firm uploads an appropriate
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confirmation message, again as a computer file, onto
the bulletin board to confirm execution of the trade
order. This confirmation message is downloaded, in
turn, by trade execution system 70 for review and later
' 5 reconciliation, by accounting computer 80, against
issued orders.
Alternatively, trade orders can also be
placed through the NYSE Super DOT system. This avenue
provides cost-effective execution for relatively small
blocks of shares, but only for those securities that
trade on the NYSE. If this avenue is selected by the
analyst for a given trade order, trade execution
computer 70 appropriately converts the trade order into
an appropriate format required for DOT execution and
then routes the order so formatted, as a message, to
NYSE DOT System 110 for execution. To do so,
computer 70 establishes a modem connection, via
dedicated line 98, to DOT computer 102 at a brokerage
firm, here firm 100, that participates in the Super DOT
system. Though, for ease of understanding and
discussion, DOT computer 102 is shown separate from any
of brokerage order execution systems 130, in practice,
this DOT computer can be implemented as part of any of
these order execution systems. Once this order is
electronically transmitted, as a message, to DOT
computer 102, this computer, in turn, electronically
transmits that order, via dedicated line 107, to Super
DOT system 110 itself. Within system 110, the order is
first routed to SIAC (Securities Industry Automation
Corporation) computer 112 which, in response thereto,
either accepts or rejects the order. Based on whether
the order is accepted or rejected (typically because a
security in the order does not trade on the NYSE) by
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the Super DOT system, STAC computer 112 generates a
suitable acknowledgment or rejection message, and
transmits that message back to DOT computer 102 at
participating broker 100. This computer, in turn,
transmits this message back through dedicated line 98
to trade execution computer 70 for subsequent use
thereat. For those orders that are accepted,
computer 112 parses the trade order into an appropriate
buy or sell order for each different security listed
therein and generates a suitable transaction (i.e. buy
or sell) message for each such different security.
Computer 212 then routes these messages to common
message switch 115, which, in turn, routes each such
message to an appropriate station, on a trading floor
of the NYSE, which is manned by a "floor specialist"
who makes and manages a market in the corresponding
security. Eligible trades are matched and executed by
the specialists in accordance with NYSE rules. All
orders, whether through the Super DOT system or other
on-exchange avenue(s), for any security traded on the
NYSE are ultimately routed through a floor specialist
for that security. Inasmuch as the NYSE utilizes a
significant number of specialists, some of whom make
and manage markets in just one or more than one traded
security, these specialists are denoted as
specialists 120 with individual floor specialists 1201,
1202, ..., 120n. The stations (though not specifically
shown) utilized by specialists 120 are connected to
common message switch 115 through lines 118,
specifically lines 1181, 1182, . . . , 118n for
specialists 1201, 1202, ..., 120n, respectively. Orders
for those specific securities that have formed part of
a trade order but could not be traded through the Super
DOT system are executed by participating broker 100.
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For each of these orders, broker 100 generates an
appropriate confirmation message and routes that
message back, via dedicated line 98, to trade execution
computer 70 for subsequent reconciliation by accounting
' 5 computer 80.
Apart from use of the bulletin board and
Super DOT trading avenues, trade orders can be placed
directly with a given brokerage firm which, in this
case, acts as a principal. This avenue, referred to as
a "principal trade", is generally selected by the
analyst for trading larger blocks of shares than
through either bulletin board or Super DOT system.
Once the analyst has selected a principal trade for a
given trade order, computer 70 establishes a modem
connection, via line 78 and PSTN 40 and lines 135, to a
desired brokerage firm. Once this connection is so
established, a conventional so-called "trade
statistics" package is transmitted, as, e.g., a
message, directly by computer 70 into the order
execution system at that brokerage firm. Such a
package is directly transmitted, in this fashion, to
several different brokerage firms for competitive
bidding thereamong. Once each of the brokerage firms
receives the package, an appropriate employees)
thereat analyzes the package and, if the brokerage firm
is interested in executing the package, telephones a
voice message to the analyst with its single bid, i.e.
on a total cost basis, for handling the complete
package. The analyst then appropriately reviews and
analyzes these bids, selects a winning bid and so
notifies the associated "winning" brokerage firm
usually by telephone. Thereafter, the analyst posts a
file containing all the actual individual trade orders
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that are to be executed, and which the statistics
package represents, onto the page of the electronic
bulletin board for the winning broker. That broker,
through its order execution system, retrieves this file
and then executes, to the extent it itself can, all the
individual orders listed therein. Those individual
orders which that brokerage firm can not fully execute
internally, for whatever reason, are executed by that
broker through alternate avenues. While the market is
open, these alternate avenues for such an order
include, e.g., routing that order to the station of the
floor trader at NYSE trading floor for that brokerage
firm who then, in turn, presents the order for each
security being traded to the floor specialist for that
security in an attempt to match the trade with an
opposite party and hence execute the trade. As such,
the order execution systems at the brokerage firms are
connected, via collectively lines 133, to the NYSE
trading floor, with specifically order execution
systems 1301, 1302, . . . , 130m connected by lines 1331,
133, ..., 133m to appropriate trading stations located
on the trading floor. Once the brokerage firm executes
the trade order, that firm posts a file, to electronic
bulletin board 75, which specifies those individual
trades within the trade order that have been executed.
This file is subsequently accessed, from bulletin
board 75 and via LAN 77, by accounting computer 80 for
subsequent reconciliation.
A further trading avenue involves so-called
off-exchange trading. This avenue utilizes so-called
crossing networks 90, of which Instanet system 92 and
POSIT system 94, are two examples of such networks.
Each of these networks receives buy and sell orders
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electronically transmitted directly from interested
parties who are connected to that network, matches the
buy and sell orders for each security at each different
price level and executes the orders thereamong and
returns appropriate confirmation messages. Generally,
this avenue provides cost-effective trading for
relatively small blocks of shares. These systems,
which by-pass any exchange, can accommodate nearly any
security. If this avenue is selected by the analyst,
computer 70 establishes a modem connection, via line 78
and PSTN 40, to the selected crossing network, such as
through line 91 to Instanet system 92 or via line 96 to
POSIT system 94. Once this connection is established,
computer 70 transmits a properly formatted message for
each security to be traded which specifies, inter alia,
the name of the security; the type of trade sought,
i.e. buy or sell; the number of shares involved; and
the price at which the trade is to be executed.
System 92 or 94, depending upon which is used for a
given trade, will issue and transmit a message back
through PSTN 40 to computer 70 confirming which trades
have been executed, and after a trade has been pending
for a given amount of time, which trades have not been
executed. Trade confirmation messages are routed by
computer 70 to trade generating computer 60 to
expeditiously update the data, specifically the current
portfolio holdings, locally stored therein. In
conjunction with appropriate instructions issued by the
analyst, those trades, that have not been executed by
the corresponding crossing network to which that trade
has been posted, are re-formatted by computer 70 and
posted as a trade order to bulletin board 75 for
execution as an agency trade.
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Once all trades, for a given portfolio
rebalancing operation, have been executed during a
given trading session, by whatever avenues) are
selected, these trades are automatically verified,
typically after the markets have closed for that
session. To verify trades, trade confirmations are
also sent by each of the brokerage firms involved as
well as the off-exchange trading systems to trade
verification system 140 (which executes at Depository
Trust Corporation). System 140 matches each side of a
trade, either the buy or sell, with the other side,
and, in so doing, flags all mis-matched trades for
subsequent resolution by the party(ies) involved.
System 140 then generates appropriate electronic
reports. Such a report, for each different portfolio
managed by system 65, is electronically sent, via
line 146, directly to accounting computer 80 for use
during subsequent account reconciliation.
In particular, to verify trades, system 140
is connected, via lines 93, 95, 144 and 142 (formed of
individual lines 1421, 1422, ..., 1420 , to Instanet
system 92, POSIT system 94, participating broker 100,
and brokerage native order execution systems 130
(specifically order execution systems 1301, 1302, ...,
130m), respectively.
For all verified trades, system 140 also
supplies, typically on a batch basis for all trades
that occurred during an immediately prior market r
session, appropriate transaction information to
appropriate transfer/disbursing agents, and
specifically to database and accounting systems I50
thereat. This information permits these agents to
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update their shareholder records to properly reflect
changes in share ownership for each of their client
' organizations that occurred during this prior market
session. Inasmuch as different issuers utilize
' 5 different transfer/disbursing agents, trade
verification system 140 routes cleared trade
information, via lines 153 and specifically lines 1531,
1532, ..., 153j, for each security to the appropriate
database and accounting system 1501, 1502, ..., 150 at
the transfer/disbursing agents for that particular
security. For those securities that pay a dividend,
each of the transfer/disbursing agents, specifically
database and accounting systems 150 thereat and in
response to electronic payment instructions received
over lines 157, disburses dividend payments to the
appropriate shareholder accounts. Tnasmuch as
custodial bank 150 holds all securities and cash,
typically in electronic form, in each portfolio being
dynamically managed by system 65, database and
accounting systems 150 provide messages containing
dividend payment information, via lines 155,
specifically lines 1551, 1552, . . . , 155 from database
and accounting systems 1501, 1502, . . . , 150, to
custodial bank 160. With this information, custodial
bank 160 updates the cash balance in each such
portfolio to reflect the payment of dividends.
Furthermore, accounting system 80 verifies
trades in the portfolio based on confirmation messages
trade execution computer 70 has received during the
immediately prior market session. System 80 then
transmits, via lines 82 and 165 and PSTN 40, a file,
containing information specifying verified trade
executions, to custodial bank. accounting system 160.
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System 160, based on the file received from accounting
system 80 and trade information independently received
from trade verification system 140 via dedicated
line 163, compares this information to properly
corroborate the trades and detect any mis-matched
trades.
A file containing fully verified trades,
mis-matched trade information and current cash
balances, is provided by custodial bank accounting
system 160, via a modem connection through lines 165
and 82 and PSTN 40, back to accounting system 80. This
file is used by accounting system 80 to: (a) update the
current portfolio holdings to reflect matched trades;
and (b) initiate, with appropriate human intervention,
a resolution of each mis-matched trade. Updated
portfolio information, specifically all current stock
positions and cash balance, is then stored within trade
generating computer, specifically dynamic portfolio
management system 65 thereat, for use during the next
successive dynamic portfolio rebalancing operation.
Once trades have been verified and mis-
matched trades resolved, to the extent possible,
- custodial bank accounting system 160 establishes a
direct connection, via line 163, to trade verification
system 140 to settle the matched trades by authorizing
appropriate transfer transactions in the accounts of
the associated transacting parties. Though only one
custodial bank accounting system 160 is specifically
shown, system 65 can dynamically manage several
different portfolios, each being held by a different
custodial bank. In that case, database and accounting
systems 150 would route appropriate dividend
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information to each of the custodial banks reflective
of their current holdings, with each of these custodial
banks separately clearing trades, that involve its
holdings, through trade verification system 140.
For simplicity, I have intentionally omitted
details of the computerized order entry and trading
mechanisms used on all exchanges other than the NYSE,
and have very generally represented the trading systems
ZO for the NASDAQ and American exchanges, as NASDAQ system
170 and AMEX system 180, respectively. The omitted
details, which are all conventional, and their proper
integration into system 5 will be readily apparent to
anyone skilled in the art.
FIG. 2 depicts a high-level block diagram of
the hardware components that implement computer system
50 and particularly trade generating computer 60
therein, as shown in FIGS. 1A-1D. As shown in FIG. 2,
system 50 contains trade generating computer 60 - which
directly implements my present invention, trade
execution computer 70 and accounting computer 80.
Inasmuch as trade execution computer 70 and accounting
computer 80 have already been discussed in sufficient
detail for purposes of the present invention, I will
omit any further discussion of these two computers and
turn to trade generating computer 60.
Computer 60, which is preferably a specially
programmed workstation or personal computer, comprises
input interface (I/F) 210, processor 220,
communications interface 230, memory 240 and output
interface 250, all conventionally interconnected by
bus 260. Memory 240 generally includes different
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modalities, such as semiconductor read only memory
(ROM) and random access memory (RAM) 244 and disk based
storage (and appropriate interface) 248, and
collectively stores an operating system (O/S) and
application programs. The specific software modules
and accompanying data that collectively implement the
inventive dynamic portfolio management system reside
within the application programs, as shown in FIG. 3 and
discussed in detail below.
Incoming data, particularly current share
price and share price changes provided by the satellite
receiver and other sources, including S & P 500 data,
are provided via lines 12 and 66, respectively, to
- computer 60, and particularly to input interface 210
therein. This interface contains appropriate circuitry
to provide the necessary and corresponding electrical
connection, e.g. direct or modem interfaces required to
physically connect and interface each differing source
of input data, to computer 60. In addition, input
interface 210 electrically connects and interfaces user
input device 290, such as a keyboard and mouse, to
system 60. Display 270, such as a conventional
monitor, and printer 280, such as a conventional laser
printer, are connected, via corresponding lines, to
output interface 250. Output interface 250 provides
requisite circuitry to electrically connect and
interface the display and printer to system 60.
Accounting computer 80 and trade execution computer 70
are both connected, through LAN 77 and via
communications interface 230, specifically a network
adapter therein, to computer 60.
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In operation, the dynamic portfolio
management system is periodically executed, usually
during market hours, to: analyze current changes in
share price and current S & P composition and
' 5 weightings, calculate new positions in each security
held in the portfolio and issue appropriate market
trade orders to appropriately update the portfolio
holdings to reflect these new positions. The portfolio
management system can be executed on any periodic
basis. Based upon the total shares contained in the
portfolio for each different security and the attendant
transaction costs (i.e. trading ticket charges) -
which, on the margin, decrease substantially as larger
share blocks are traded, the management system may be
run either weekly, for portfolios that contain a
relatively small position in each different security,
or more often, such as daily, hourly or at even shorter
intervals as the size of the portfolio increases.
Inasmuch as my inventive management method favorably
accounts for market volatility which increases with
shorter sampling intervals, increased performance will
likely occur with increasingly shorter trading
intervals for correspondingly larger portfolios. The
interval can be set through an appropriate timer,
slaved to a real-time clock, in the operating system.
An analyst stationed at computer 60 can
select a particular trade avenue for each trade order
as well as set parameters and supply other user
information, or through appropriate mouse-based user
selection enter queries to obtain current portfolio
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and/or market information, through appropriate commands
entered via device 290 and in response to a program
icon or selection menu appearing on
display 270.
Inasmuch as the specific hardware components
of system 60 as well as all aspects of the software
stored within memory 240, apart from those modules that
implement the present invention, are conventional and
well-known, they will not be discussed in any further
detail.
B. Software and Su ortin Equations
1. High level overview
FIG. 3 depicts a high-level block diagram of
the software (computer executable instructions)
resident within memory 240 and executing within trade
generating computer 60.
As shown and in pertinent portion, these
programs include operating system 310 and application
programs 320, the latter containing inventive dynamic
portfolio management system 65. System 65 is formed of
management program 330, which itself collectively
contains main program 600 and routines 700, 800, 900
and 1000 (which are shown in FIGS. 6A-6C, 7A and 7B, 8,
9A and 9B, and 10A and 10B, respectively, all of and
- described in accompanying text below). Currently, with
~.~'ade ~enerat5.ng cc~mpu~er 60 (see FIG. 2) implemented
on a personal computer, operating system 310 is
illustratively a DOS based operating system, such as
MS-DOS (Microsoft Disk Operating System available from
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the Microsoft Corporation of Redmond, Washington), with
application programs 320 being written in the C
Programming language and compiled, under a Microsoft C
compiler, for DOS execution. My present invention can
' 5 be implemented in any one of a wide variety of
different programming languages and hence can be
readily adapted for execution under any one of many
different operating systems, based on the computer
system chosen to implement trade generating
computer 60.
Incoming share prices, share price changes
and S & P 500 information (composition of the index
and current shares outstanding), supplied to dynamic
portfolio management program 330, are collectively
symbolized by line 305. The resulting trade orders
generated by program 330 is symbolized by line 340. In
addition to programs 330, system 65 also includes
accompanying stored data 325. This data, residing on
fixed disk storage within memory 240, contains current
portfolio holdings, in terms of, e.g., the names of
each security held, the number of shares outstanding
for that security, a current cash balance, and various
predefined parameter values. Input to data 325, in the
form of a cash balance and trade results, is
collectively symbolized by line 308. Data 325 is
illustratively stored in ASCII based files (effectively
implementing a data base) with appropriate conventional
programs used to download the incoming market data,
from the satellite receiver, and the S & P 500 data,
from the S & P information server, and update these
data files accordingly. Furthermore, accounting
computer 80 also updates the portfolio data in a
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conventional manner with verified trade information, as
described above.
2. Process diagram
FIG. 4 depicts process diagram 400, which
shows various high-level operations that, within the
context of system 5 shown in FIGS. 1A-1D, collectively
implement my present invention.
As shown, the present invention utilizes six
distinct high-level operations: 410, 420, 430, 440, 450
and 460. Information incoming from external market
sources, such as the real-time market quite satellite
feed and the S & P 500 information, as symbolized by
lines 403 and 406, are first obtained from these
sources through operation 410. The resulting market
information is then provided as input and as symbolized
by line 415 to operation 430. Operation 420 accesses
locally stored portfolio data, including both current
security holdings and cash balance, and also applies
this stored data, as symbolized by line 425, as another
input to operation 430. Based on the market data and
stored portfolio data, operation 430 determines the
appropriate weighting for each security then in the
portfolio to properly rebalance the entire portfolio.
As a result of this operation, operation 430 issues
appropriate trade orders, as symbolized by line 437, to
either buy or sell securities, as much as necessary, in
the portfolio to effectuate the rebalancing. Once the
trade orders are issued, process 440, currently
implemented manually by an analyst working
interactively with trade execution computer 70 (see
FIGS. lA-1D), as discussed above, will analyze each
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trade order to determine the proper avenue for its
execution and will place that order accordingly for
' off-exchange trading (either through the Tnstanet or
POSIT systems), a principal trade, an agency trade
' 5 (through electronic bulletin board 75 shown in
FIGs. lA-1D and discussed above), or through the NYSE
Super DOT system - with these alternatives symbolized
by lines 442, 444, 446 and 448, respectively. The
stored portfolio data will be updated, as symbolized by
line 433, to reflect a list of pending trades resulting
from operation 440 such that a particular trade will
not be erroneously re-issued. Once the trade has been
appropriately placed, that trade is executed (or at
least execution is attempted) through process 450.
Once the trade has been executed, specific trade
information, as to whether the trade order fully or
partially executed and what particular-positions were
traded and the specifics therefor and symbolized by
line 455, are applied as input to accounting
operation 460, which includes trade verification. The
output of operation 460, in the form of a cash
position, verified trades, mis-matched trades and other
error conditions, is used, as symbolized by line 465,
to update the locally stored portfolio data
subsequently accessed by operation 420 during the next
portfolio rebalancing operation, as so forth.
3. Dynamic portfolio rebalancing equations
In accordance with my inventive teachings, I
have recognized that, for a portfolio, Y, such as an
index fund, that holds a pre-defined universe of
securities which collectively forms a capitalization
weighted index, such as the S & P 500 index, by
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dynamically re-weighting the position of each security
in the portfolio in a manner proportional to a
non-constant function of current capitalization weights '
of the securities in the index, then, for appropriately
selected functions, the resultant return generated by a '
portfolio will consistently and reliably outperform
that of the index itself.
In particular, given current capitalization
weights, W1, W2, ..., Wn of a capitalization index, such
as the S & P 500 index, I have recognized that if a
"generating" function S = S (W1, W2, . . . , Wn) is a twice
continuously differentiable non-constant function of
these weights, then each security in the portfolio, Y,
I5 should have a weight, V;" given by equation (1) below.
D. S W , l
Y. = 1 ~ 1 W2'..., nl +1 - ~ W D S(Wl,W2,..., n~ W. 1
( )
S(W1,W2,..., n~ j=1 S(W1,W2,...,~ )
for i = l, ..., n,
where: Di and DJ are partial derivative operators with
respect to the ith and jt-'''' variables, i . a . here with
respect to variables Wi and Wj, respectively.
In this case, equation (2) holds as follows:
d InCZ~ =d 1nS + O dt (2) .
where d In (Y/Z) represents the relative performance of
- the re-weighted (dynamically managed) portfolio Y
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measured against performance, Z, of the index itself
d In S represents a logarithmic change in the
' generating function S; and O measures a rate of
differential relative performance between the index
itself and the dynamically managed portfolio Y. This
differential performance is affected by dividend rates
of the two portfolios, the volatility of these two
portfolios, and "leakage" of stocks from the index,
i.e. stocks which were eliminated from the index itself
because their market capitalization sufficiently
decreased. I have found that excellent performance
occurs where a function that measures diversity of
distribution of capital among the stocks in the index
is employed for generating function S. Such a
diversity based function is typified by entropy or a
diversity based measure, DP, as set forth below in
equations (3) and (4), respectively.
n
S~W1,W2 ,..., n~ _ - ~ W. 1nW (3)
i=1
n
SCW1,W2 ,..., n~ _ ~ W.p 1/p (4)
i=1
For values of diversity exponent p in the range of
0 < p < 1, both generating functions produce portfolios
characterized by reliably positive values of O and
stable values of In S. Furthermore, the generating
function Dp shown in equation (4) possesses an
advantage of being parameter dependent and adjustable.
As discussed in detail below, both equations are
appropriately used in my preferred embodiment. Through
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empirical analysis, I have found that setting the value
of exponent p equal to .76 produces a portfolio that
consistently yields, over a simulated 16 year test
interval - as discussed in detail below in conjunction
with FIGS. 11-13, an annual return that exceeds that of
the S & P 500 index by approximately 40-50 basis
points (bp).
For my detailed theoretical analysis in
support of these equations, the reader is referred to
my following papers: °°On the Diversity of Equity
Markets'°, Enhanced Investment Technologies, Inc.,
(~ 1995, 1996, Intech, Princeton, New Jersey);
"Leakage in Dynamic Index Portfolios", Enhanced
Investment Technologies, Inc.(~ 1996, Intech,
Princeton, New Jersey); and "Dynamic Index Portfolios
and Equity Market Stability", Enhanced Investment
Technologies, Inc., (~ 1995, 2996, Intech, Princeton,
New Jersey) which are all incorporated by reference
herein and which are the subject of my co-pending
United States provisional patent application entitled
"Automated Investment Portfolio Construction", serial
number 60/021,116 filed July 3, 1996. An earlier
version of the first paper, which is also incorporated
by reference herein, is the subject of my earlier filed
and co-pending United States provisional patent
application entitled '°Automated Investment Portfolio
Construction", serial number 60/008,698 filed December
15, 1995. In addition, for additional supporting
theoretical analysis, the reader is also referred to my
following paper: ''Dynamic Equity Tndices", Enhanced
Investment Technologies. Inc. (~ 1995, 1996, Intech, -
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Princeton, New Jersey), which is also incorporated by
reference herein.
4. Dynamic Portfolio Management Main Program and
' S routines called thereby
Prior to discussing my inventive software in
detail, i.e. the main program and its attendant
routines, the reader is directed to FIG. 5 which
defines those variables used in conjunction with this
software. For easy reference, these variables are
grouped into four classes: global parameters 510,
variables 520 that pertain to a given portfolio
(account), variables 530 that pertain to each
individual security in the S & P 500 index, and
variables 540 that pertain to each security in a given
account. To facilitate understanding,-the reader
should simultaneously refer to this figure throughout
the ensuing discussion of Main Program 600 and
routines 700, 800, 900 and 1000 (collectively shown in
FIGs. 6A-10B). Each of these variables will be
discussed in detail when it first arises during the
ensuing discussion.
a. Main Program 600
FIG. 6 depicts the correct alignment of the
drawing sheets for FIGS. 6A-6C;
A high-level flowchart of my Main Program 600
of my inventive Dynamic Portfolio Management System is
collectively depicted in FIGs. 6A-6C~ the correct
alignment of the drawing sheets for these figures is
shown in FIG. 6.
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Upon entry into Main Program 600, execution
first proceeds to block 605. This block, when
executed, determines by virtue of the state of two
user-settable flags, i.e. a "rebalancing" flag and a
"cash investment mode" flag, which of two portfolio
management modes are to be currently performed.
Through the rebalancing mode, weights of each security
in the portfolio are re-calculated and the portfolio
holdings dynamically rebalanced with resulting issuance
of appropriate market orders. Alternatively, through
the cash investment mode, transactions are generated to
consume excess cash (e.g. large cash inflows) in the
portfolio that may have arisen as a result of recent
dividend payments) and/or security sales without
sufficient offsetting purchases. Variable ~VI is set to
one if rebalancing is to occur; to zero otherwise, i.e.
cash investment is to be executed.
Thereafter, execution proceeds to block 610,
which throu~~~~ block 615 executed therein, performs
various initialization operations, specifically reading
various predefined and stored limit values and setting
various threshold values. The numeric and illustrative
values which I currently use are set forth in
- parentheses. In that regard, an assumed trading cost
variable is set to illustratively $ .15/share to
reflect ticket (brokerage) charges. This charge can be
set to a lower number, or an appropriate function of
share volume to be traded, in order to accurately
reflect marginal cost decreases for transactions
involving increasing numbers of shares. A large price
change threshold is set to illustratively 10~, i.e. a
large price change flag for a given security is set
whenever a share price change of more than 10~ is
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detected from the last time rebalancing occurred. A
large share price change threshold is set to
illustratively 20~, i.e. a large share change flag will
be set whenever a trade order issues to sell more than
20~ of the shares currently held in any one security in
the account. A minimum trade size, 1N, as a percent of
current holdings, is set at illustratively .01g, i.e.
trades in a security will not be executed for less than
.01~ of the portfolio value. A minimum buying price
variable, P, at which a security will be bought is set
to illustratively $ .01. A variable, C, will be set
to illustratively .02~ to reflect the maximum amount of
cash, as a percentage of total current portfolio value,
that is to be maintained, i.e. not invested during
dynamic rebalancing. A variable, C', is also set to
reflect the maximum amount of cash, illustratively .2~,
as a percentage of the total current portfolio value
that is to be maintained before the cash investment
mode is automatically invoked. A variable, B, is
illustratively set to 5s, as a stock trading band. In
that regard, if the actual weighting, as a percentage
of the total portfolio, at which a security is
currently held lies within a range of the "target"
weighting determined through rebalancing, this range
being the stock trading band (here illustratively k5~
of the weight), then no trade is triggered to change
the holding in this security. Lastly, the exponent for
dynamic rebalancing, referred to above as p and
hereinafter also referred to as ,~', is illustratively
set to the value 0.76.
r Once block 615 has fully executed, execution
proceeds from block 610 to block 620. This latter
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block first obtains market share price and share price
change data from the real-time market data feed, e.g.
the satellite feed, and S & P composition information
from the S & P 500 Tnformation server. Specifically,
this block obtains security information for each
security in the S & P 500 in terms of: a ticker symbol
(as used in the NYSE to identify the security by name),
a CUSTP number (a unique alphanumeric identifier for
each different security), a security name, current
price (here denoted as pi and not to be confused with
exponent p above), total number of shares outstanding,
st, and a change in price from the previous market
close. Once this data is obtained, block 620 organizes
this data in ascending order by CUSIP number, and
ensures, for error checking, that all price data is
positive - with appropriate changes being made, through
involving proper human intervention, to appropriately
correct negative price data (which is clearly
erroneous). In the event that the price for any
security has changed in excess of the large price
change threshold, typically 10~ as noted above, then
the large price change flag is set for that security.
Based on the data reflecting the current securities in
the S & P 500, the total number of shares outstanding
of each of these securities and its current price,
block 620 then calculates the S & P 500 weighting for
each security currently contained within the S & P 500
index. Once these operations are complete, execution
exits for the entire trading day from block 620. This
same information is used with respect to each different .
portfolio that is to be dynamically rebalanced with
respect to the S & P 500 index. Alternatively, if
another capitalization weighted index(indices), other
than the S & P 500 index, is to be used, then block 620
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would be suitably modified to obtain similar data but
pertinent to the securities held in that
V
index(indices). Thereafter, execution proceeds to
block 625 which reads a "global posted stock list".
This list contains securities, in CUSIP order, that can
not be traded, for one reason or another, in any
portfolio (account) currently being dynamically
managed. Thereafter, execution proceeds to block 630
which obtains a list of accounts (different portfolios)
that are to be dynamically rebalanced. The value of
variable n is set to the total number of such accounts
to be managed.
Thereafter, each separate account is then
managed, through either of the two modes, i.e. its
holdings are either dynamically rebalanced or its cash
position is modified through cash investment. In that
regard, execution now proceeds to block 635 which sets
the value of an index variable, ACCOUNT INDEX, to one,
i.e. to point to the first account to be managed. From
this point, the program iteratively executes account
management block 640 for each separate account to be
managed, after which execution exits from main
loop 600.
In particular, when execution enters account
management routine 640, block 650 is executed for the
next successive account to be managed, i.e.
ACCOUNT(ACCOUNT-INDEX). Upon entry into block 650,
execution first proceeds to block 652 which, when
executed, reads data for the current holdings in this
particular account. To prevent errors, this data
includes a "key" which is common to each file for a
given account. In the event a "key" read for a file
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for the current account does not match the predefined
key established for that account, an appropriate error
message is generated to invoke human intervention.
Other parameters for this account, such as its current
cash balance, K, and the date the account was last
dynamically rebalanced are read by block 652 (see
FIGS. 6A-6C) as well. This block also ensures that the
data files for this account are organized in ascending
CUSIP order and changes the files, as needed, to
reflect this ordering. For consistency, block 652 also
checks that each security stored in the data for the
portfolio currently exists in the S & P 500; otherwise,
that security (i.e., the entire holdings therein) is
flagged for sale. For each security currently held in
the portfolio, block 652 retrieves the number of shares
currently held, ai, and ensures, by appropriate
correction, that this number is positive. Should this
number be negative - which signifies an error
condition, then the program halts pending proper human
intervention to correct the error. In addition,
block 652 reads pending share indicators, i,
(should
they exist) for each security. These indicators
signify that a trade has already been previously sent
for execution for that security to the market but has
not yet occurred. If the portfolio is rebalanced at
rather long intervals, such as weekly or monthly, then
all trade orders will have been settled well before,
and with most likely no pending trades in existence,
the next time dynamic rebalancing is to occur. Once
block 652 has fully executed, execution proceeds to
block 654. This latter block reads a local list of
securities which for one reason or another, can not be
traded in the present account, such as portfolios that
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are directed to "socially responsible" companies, i.e.
without, e.g., tobacco related stocks, and other such
restricted portfolios. Block 654 ensures that the
security data read for this list is organized in
S ascending CUSIP order as well, with the proscribed
CiISIP value, ii, of each security noted along with a
total number of such securities in the list and makes
appropriate corrections to this organization, if
necessary. Thereafter, block 656 is executed to read a
local "posted" list for the account which delineates
those securities, by CUSIP number, that have been
previously designated as being "proscribed". Block 656
then updates this posted list with any additions or
deletions based on the list read by block 654 in order
to reflect changes in the securities that have been
proscribed from being traded in the account.
Thereafter, execution proceeds to block 658
which executes Target Proportion routine 700. This
routine, shown in FIGS. 7A and 7B and discussed in
detail below, determines the dynamically rebalanced
weight (i.e. "target proportion") for each security
currently held in the account. Once this occurs,
block 662, shown in FIGs. 6A-6C, executes to invoke
Current Proportion Determination routine 800, shown in
FIG. 8 and discussed in detail below, which determines
the weighting, as a proportion of the total asset value
of the account, at which each security therein is
currently held. Once this occurs, execution proceeds
. 30 to block 664, shown in FIGS. 6A-6C, which invokes Trade
Determination routine 900, shown in FIGS. 9A and 9B and
discussed in detail below. This routine determines
whether a trade is necessary in each security held in
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the account and generates a trading list. In
particular, if this routine concludes that a trade is
necessary for a given security in the account, then the
routine determines the appropriate order to either buy
or sell the security and in what share quantity, and
hence rebalance the holding of that security in the
account, and enters that order to a trading list.
Execution then proceeds to block 666, shown in
FIGS. 6A-6C, which invokes Cash Control routine 1000
(see FIGS. 10A and 10B and discussed in detail below)
to invest any excess cash, if any, then held in the
account.
Once block 666 has fully executed, execution
proceeds to block 668. This latter block, when
executed, checks integrity of the trading list
generating by routine 900. This checking first
involves assessing whether a resulting cash balance in
the account is negative. Since negative cash balances,
at this point in the program, are not allowed, any such
negative condition is an error condition requiring
human intervention to resolve, such as by invoking the
cash investment mode to sell appropriate positions in
order to raise sufficient minimum cash. In addition, a
flag is set and a warning message generated if the
trading list contains an order involving a proscribed
security. Furthermore, a warning message is provided,
and a trade type indicator, vi, for the security is set
to "S°' (for '°Short") , if a potential sale leads to a
negative share position, i.e. a so-called "short sale". -
Such negative positions are also not permitted and
signify a need for human intervention to correct. -
Alternatively, if an order involves more than 200
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shares of a given security and if the trade represents
a greater fraction than the large share change
threshold (currently set to 20~) of the holdings in
that particular security, then the large change
' 5 indicator is set appropriately to signify this (if it
has not already been so set). Thereafter, block 668
calculates the total number of the buy and sell orders,
the total number of the shares to be traded and the
total number of trades in the trading list to be
executed. Once this is accomplished, block 668
calculates the return provided by the account since the
previous market close. Lastly, block 668 provides as
output, illustratively in printed form, the number of
trades to execute, the immediately prior and now
rebalanced account (portfolio) holdings and value, cash
balance in the account and the returns on both the
account and the S & P 500 index. Execution then exits
from block 668.
At this point, two output files containing
trade orders and other information are generated.
To generate the first file, execution
proceeds to block 672 which generates an output trade
ticket file (i.e. a "trade" file) from the trading
list. This file, which will ultimately be supplied to
a broker forexecution, through a selected trading
avenue, contains the number of the account (individual
portfolio) in which all these trades are to occur; the
current date; and for each trade: the ticker symbol of
each security to be traded, whether that trade is a buy
or sell, the number of shares to be~traded, the current
price of the security and the CUSIP identifying that
security. This file is sorted with sell orders
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preceding buy orders and the trades for each then
ordered in ascending CUSIP order.
Once this trade file has been fully
generated, execution proceeds to block 674 which
generates a "proportional change" file for the account,
i.e. for ACCOUNT(ACCOUNT_INDEX). This file contains
various information, to wit for each security in the
account: (a) the name of that security; (b) the ticker
symbol therefor; (c) the number of shares currently
held or a flag indicating either that this security is
posted (i.e. proscribed from being traded) or has a
trade pending; (d) the current and target proportions
for this security, (e) the proportion target proportion
15- after the trade and relative to the S & P 500
proportion (weighting), (f) the actual proportion that
will exist after the trade; (g) the large change
indicator; and (h) a trade type indicator. This trade
type indicator will be set to: °'C" for a cash control
trade, "S" for an attempted short sale, "P" for a
proscribed security, or "0" for liquidation of a
security for which the target proportion has been set
to zero. Thereafter, block 674 will print a file
header with an appropriate warning if: a proscribed
security were to exist in the account, the cash balance
in the account were to be negative, or a short sale
were to be attempted. This block will also print: the
current portfolio value, the current cash level, the
present return, the S & P 500 return, and a return of
the account relative to that of the S & P 500.
Block 674 will also print a file footer containing: the
total number of shares to be sold, the total number of
shares to be bought, the total number of shares to be
traded, the total number of trades to be executed, an
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amount by which the current cash balance in the account
is to change, the current cash balance in the account,
and old and new cash proportions in the account
(proportions of account value attributable to cash).
The proportional change file is sorted in order of sell
orders, buy orders and posted or pending securities.
Once this file is completely generated, execution
passes to decision block 676 to test for any attempted
short sales. If such a sale is detected, then, since
short sales are not permitted, an error condition has
occurred. Hence, execution exits from program 600, via
YES path 678 emanating from decision block 676.
Appropriate human intervention is then solicited to
investigate and resolve the error. Alternatively, if
decision block 676 does not detect any attempt at a
short sale, then it routes execution, via NO path 679,
to block 680. At this point, the security holdings in
the account have been completely processed and, as
such, the underlying portfolio dynamically rebalanced.
Accordingly, decision block 680 then executes
to determine if all accounts (different portfolios)
have been managed. If another account remains to be
managed, i.e. the current value of variable
ACCOUNT-INDEX is less than the value n, then decision
block 680 routes execution, via NO path 685, to
block 690. This latter block, when executed,
increments the value of variable ACCOUNT-INDEX to point
to the next successive account to be managed.
Execution then loops back, via path 695, to iteratively
execute account management routine 640 for this next
successive account, and so forth. Alternatively, if
all the accounts (different portfolios) have been
separately managed, each through a separate execution
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of routine 640, i.e. the current value of variable
ACCOUNT-INDEX equals the value n, then execution simply
exits, via YES path 682, from Main Program 600.
b. Target Proportion Determination routine 700
A flowchart of Target Proportion
Determination routine 700 that is executed by Main
Program 600 is depicted in FIGS. 7A and 7B; the correct
alignment of the drawing sheets for these figures is
shown in FIG. 7. As noted above, routine 700
determines the dynamically rebalanced weight (i.e.
"target proportion") for each security currently held
in an account to be processed, i.e.
ACCOUNT(ACCOUNT_INDEX) and for which trading is
permitted.
Upon entry into this routine, execution
proceeds to block 705. This block, when executed,
forms a set of securities, i.e. SECURITY_SET, which
have securities that are in either or both the S & P
500 index and the account. These include the
securities, that are to be dynamically managed in the
account. Weights are calculated and assigned for all
the securities for which trading is permitted. Once
this set is established, block 710 is executed. This
block initializes an index variable, i, to the value
°'one" and sets a variable, m, equal to the number of
securities in the account to be processed, i.e. in
ACCOUNT(ACCOUNT INDEX}.
Thereafter, execution enters a loop composed .
of blocks 7I5, 720, 725 and 730 to calculate, a
temporary proportion for each security, i.e. for
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SECURITY(i), in the set. In particular, block 715,
when executed, selects a next successive security in
the set as indicated by the current value of index
variable i. Execution then proceeds to block 720
' 5 which, for each security for which trading is permitted
(i.e., i;, does not equal 1) calculates a temporary
proportion, cu;,, to be a market capitalization of that
security which is a product of a current price of that
security (pi) and a number of shares (S;,) thereof
currently outstanding. Once this occurs, decision
block 725 executes to determine whether all securities
in the set have been selected, i.e. whether the current
value of index variable i equals the value of
variable m. If a security in this set remains to be
selected, then decision block 725 routes execution, via
NO path 726, to block 730. This latter block
increments the current value of index variable i by one
in order to point to a next successive security in the
set. Execution then loops back, via path 735, to
block 715 to appropriately process that security, and
so forth. Alternatively, if all the securities in the
set have been so processed with a temporary proportion
calculated for each, then decision block 725 routes
execution, via YES path 728, to block 740. Block 740
normalizes all the values of the target proportions
(wi, i = 1, 2, ..., m) such that their total sum equals
the value one. Execution then proceeds to block 745
which re-initializes the value of index variable i to
one.
' 30
At this point, execution enters a loop formed
of blocks 750, 755, 760 and 770 to calculate the target
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proportion for each security, i.e. for SECURITY(i), in
the set for which trading is permitted. Tn particular,
block 750, when executed, selects a next successive
security in the set as indicated by the current value
of index variable i. Execution then proceeds to
block 755 which, for each security, calculates a target
proportion, ~i, for SECURITY(i), using either an
entropy or diversity measure as embodied in
equation (3) or (4) above, as a function of its current
market capitalization weighting. An entropy measure is
used for non-zero capitalization weightings (i.e.
securities in which trading is permitted) and where the
diversity exponent has been predefined as zero. Where
the diversity exponent (here ~) is set to 0.76, as in
the preferred embodiment, then, for those securities in
the set for which trading is permitted, a diversity
measure, as embodied in equation (4), is used instead
to calculate the target proportion for each such
security. Once this occurs, decision block 760
executes to determine whether all securities in the set
have been selected, i.e. whether the current value of
index variable i equals the value of variable m. If a
security in this set remains to be selected, then
decision block 760 routes execution, via NO path 762,
to block 770. This latter block increments the current
value of index variable i by one in order to point to a
next successive security in the set. Execution then
loops back, via path 775, to block 750 to appropriately
process that security, and so forth. Alternatively, if
all the securities in the set have been so processed
with a target proportion calculated for each, then
decision block 760 routes execution, via YES path 764,
to block 780. Block 780 normalizes all the values of
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the target proportions (n;,, i = 1, 2, ..., m) such that
their total sum equals the value 1. Once this
normalization has occurred, execution exits from
routine 700.
' 5
c. Current Proportion Determination routine 800
FIG. 8 depicts a flowchart of Current
Proportion Determination routine 800. This routine, as
noted above, determines the weighting, as a proportion
of the total asset value of the account, at which each
security therein is currently held.
Upon entry into this routine, execution
proceeds to block 810. This block, when executed,
calculates the total current value of the account, i.e.
ACCOUNT(ACCOUNT_INDEX). This value, V, is simply the
sum of the current cash balance, K, in the account and
the accumulated product, summed over all the securities
in the account, of the current price of each such
security (pi) and the number of shares held therein
(ai). Once this value is established, block 820 is
executed, as an error checking measure, to ensure that
this value is positive. If a negative value results,
which clearly signifies an error condition, the program
halts pending appropriate human intervention to
appropriately correct the error. Thereafter, block 830
executes to initialize index variable, i, to the value
"one".
' 30
Execution next enters a loop composed of
' blocks 840, 850, 860 and 870 to calculate, a current
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proportion for each security, i.e. for SECURITY(i), in
the set. In particular, block 840, when executed,
selects a next successive security in the set as
indicated by the current value of index variable i.
Execution then proceeds to block 850 which, for each
security in the set, calculates a current proportion,
pi, to be a market capitalization of that security
which is a product of the current price of that
security (pi) and the number of shares held therein
(ai) divided by the current value of the account, V.
Once this occurs, decision block 860 executes to
determine whether all securities in the set have been
selected, i.e. whether the current value of index
variable i equals the value of variable m. If a
security in this set remains to be selected, then
decision block 860 routes execution, via NO path 863,
to block 870. This latter block increments the current
value of index variable i by one in order to point to a
next successive security in the set. Execution then
loops back, via path 875, to block 840 to appropriately
process that security, and so forth. Alternatively, if
all the securities in the set have been so processed
with a current proportion calculated for each, then
execution exits from routine 800, via YES path 867
emanating from decision block 860.
d. Trade Determination routine 900
A flowchart of Trade Determination
routine 900 is collectively depicted in FIGS. 9A and
9B; the correct alignment of the drawing sheets for
these figures is shown in FIG. 9. As noted above, '
routine 900 determines whether a trade is necessary in
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each security held in the account and, if so, generates
the appropriate trade. In particular, if this routine
concludes that a trade is necessary for a given
security in the account, then the routine determines
the appropriate amount of shares in each security to
either buy or sell, and hence rebalance the holding of
that security in the account.
Upon entry into routine 900, execution first
proceeds to block 905. This blocks initializes various
variables. In particular, for each security,
SECURITY(i) for i = l, 2, ..., m, in the set: a
variable, Ei which specifies the number of shares to be
traded is set to zero; the trading type indicator, vf,
is set to a "blank" character; a large change flag is
set to a blank character or alternatively to signify a
large price change, if so previously set. Once these
operations have occurred for each security in the
account, then execution proceeds to block 910 which
resets the value of index variable i to one.
Once these occurs, the program enters a loop
containing blocks 915, 920, 925, 930, 940, 945, 950 and
960 to calculate the appropriate, trade if any, for
each security then held in the account. Specifically,
block 915, when executed, selects SECURITY(ij in the
set of securities, SECURITY SET, previously defined, as
described above, through execution of block 705 in
routine 700 (see FIGS. 7A and 7B). Once this security
_ 30 has been selected, then as shown in FIGs. 9A and 9B,
either one of three scenarios will govern how, if at
all, trading involving that security is to occur.
Execution will proceed, via path 918, to each of these
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scenarios, only one of which will be performed if its
accompanying test condition is met. These scenarios
are depicted as blocks 920, 925 and 930.
Block 920 handles each of those securities
which are proscribed from being traded in the
portfolio, i.e. where ii equals one. In this case, for
a proscribed security, since the security might have
become proscribed after a position has been established
therein, block 920 merely sets the amount of that
shares to be traded, specifically sold, in that
security, i.e. si, equal to the entire position
therein. A negative value of si signifies a sale of
securities while a positive value indicates a purchase,
the amount of the sale or purchase being given by the
magnitude of E;,. Inasmuch as this security is now
proscribed, block 920 also sets the trade type
indicator for this security to "P" to signify this
condition. Thereafter, execution is routed, via
paths 933 to block 940.
Block 925 handles each of those securities in
which a portion of the current holdings therein is to
be sold, or shares are to be purchased. Such a trade
will be generated only if a security and its associated
parameters meet three conditions. Block 925 first
tests the current security, SECURITY(i), for
conformance with these conditions. If any of these
conditions fails, then the remainder of this block does
not execute. In that case, either the trade will be -
governed by blocks 920 or 930, or, if not, execution
will be directed onward to block 940. These conditions
are, for SECURITY(i):
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(a} first, that:
(1} its target proportion, ~i, is positive
(2) it is not proscribed and not posted (both
ii and t/~i are zero, respectively) ;
(3) it does not have a trade pending (i.e. ~x
is zero - the importance of this being that to prevent
issuance of potentially a duplicate trade);
(4) a difference between the target and
current proportions is greater than a minimum trade
ZO proportion ( YV < ~ zci - pi ~ ) ; and
(5) that the account is to be dynamically
rebalanced ( i . a . .?1~1 =1 ) and
(b) second, that for this security:
(1) its current price (pi) exceeds a minimum
price (P) at which any under-weighted security is to be
bought; or
(2) its current proportion (pi) exceeds its
target proportion (~i); and
(c) third, that its target and current proportions
satisfy either of the following inequalities:
(1) p1 > ~cl ell : or (5)
(2) pa a ~1 < ~ . (6)
If, for any security, SECURITY(i), all three conditions
axe satisfied, then block 925 determines the amount of
- shares to be traded, i.e. a current trade, in that
security, Ei. Block 925 first calculates this amount as
- being equal to the target proportion multiplied by the
total portfolio value divided by the current price of
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this security (niV/pi) less the current number of
shares held in that security (O'i). Inasmuch as a
security trade will only be issued in round lots, i.e.
in lots of 100 share multiples, block 925 then rounds
the calculated number of shares to be traded to the
nearest multiple of 200 shares, using a centering
variable, L. This variable specifies the band,
relative to the middle of any 100 share lot, at which a
share quantity will be rounded to the next higher lot.
This variable, which is predefined for any given
account and generally constant therefor will be
increased in situations where a low cash balance exists
in the account in order to permit the cash control mode
to properly converge. In those instances where the
current proportion exceeds the target proportion, then
the trade is a sell with the number of round lots given
by:
s.
si=Int X00 - L fl. (7)
Alternatively, where the current proportion is less
than the target proportion, then the trade is a buy
with the number of shares, in numbers of round lots,
given by:
s.
E.=Int i - L . (8)
100 _
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Once the number of shares, in terms of round lots, has
been calculated, the actual number of shares to be
traded is determined simply by multiplying the number
of lots to be traded by 100, i . a . si = Ei X 100 . With
this share quantity determined, execution then exits
from block 925 and is routed to block 940. If the cash
investment, rather than dynamic rebalancing, mode is to
occur (i.e., M could equal 0}, then no trades will be
executed through block 925 for any security, with such
trades governed by executing cash control routine 1000,
as discussed in detail below, upon termination of
currently executing routine 900.
Block 930 handles each of those securities
Z5 which have a zero target proportion and a positive
current proportion (i.e. ~i equals zero, but pi is both
greater than zero, respectively}, is not posted (t/~i is
zero) and not proscribed (~ci is zero) and for which are
trade is not pending. In this case, the entire
position in that security is to be sold. This scenario
includes those securities that have been eliminated
from the index. Therefore to eliminate the entire
position in the security, block 930 sets the amount of
that shares to be traded, specifically sold, in that
security, i.e. Ei, equal to the entire position
therein. Inasmuch as the security is not proscribed,
block 930 also sets the trade type indicator, ui, for
this security to "0" to signify this condition.
Thereafter, execution is routed, via paths 933 to
block 940.
This block, for each of those securities
where a non-zero amount of shares is to be traded but
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the trade would result in a short sale, i.e. where si <
-ai, sets the amount of shares to be sold to equal the
entire position therein, i . a . si = -a~.
Thereafter, execution proceeds to block 945
which updates, based upon the current trade just
determined, the current cash balance in the account and
the current portfolio value. Specifically, block 945
updates the cash balance by first calculating the total
cost, y, associated with the current trade. This cost
is illustratively calculated as being the assumed
trading cost ($ .15/share) multiplied by the number of
shares to be traded. Other cost metrics, such as a
flat or sliding fee, can be used instead, if and when
appropriate. Once the trade cost is determined, the
current cash balance, K, itself is updated as simply
the prior cash balance less number of shares to be
traded multiplied by their price per share less the
trade cost. Lastly, the portfolio value, V, is updated
- by simply subtracting the trade cost, y. Each trade so
generated is then inserted by block 945 as an entry in
a trading list.
Once this occurs, decision block 950 executes
to determine whether all securities in the set have
been selected, i.e. whether the current value of index
variable i equals the value of variable m. If a
security in this set remains to be selected, then
decision block 950 routes execution, via NO path 953, _
to block 960. This latter block increments the current
value of index variable i by one in order to point to a
next successive security in the set. Execution then
loops back, via path 965, to block 915 to appropriately
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process that security, and so forth. Alternatively, if
all the securities in the set have been so processed,
' then execution exits from routine 900 via YES path 957
emanating from decision block 950.
e. Cash Control routine 1000
A flowchart of Cash Control routine 1000 is
collectively depicted in FIGs. l0A and lOB; the correct
alignment of the drawing sheets for these figures is
shown in FIG. 10. As noted above, this routine
generates appropriate trades to invest any excess cash,
if any, then held in the account. This routine is
executed during both the dynamic rebalancing and cash
investment modes.
Upon entry into routine 1000, execution
proceeds to block 1005 which sets a "trigger cash
proportion" variable, 8, appropriately. This variable
signifies when, given the present cash balance in the
account being processed, cash control is to be
performed for the account. Specifically, if cash
control is to solely executed, i.e. during the cash
investment mode and in the absence of dynamic
rebalancing such as would occur as a result of a cash
infusion resulting from dividend payments, then the
variable ~1 would have been set, as described above,
through execution of initialization block 605 in Main
Program 600 (see FIGS. 6a-6C), to zero. In this case,
- 30 the trigger cash proportion is set to the cash
investment trigger proportion, C', which as discussed
above is currently set to illustratively 0.2~ of the
current total portfolio value. Alternatively, if cash
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control is not to be solely performed, i.e. the program
executing in the dynamic rebalancing mode, then the
trigger cash proportion is set to the cash maintenance
proportion, which as discussed above is illustratively
.02~ of the current portfolio value. Once block 1005
has executed, execution proceeds to decision block 1010
to test the current cash balance in the account with
respect to the trigger cash proportion multiplied by
the total portfolio value. If this balance is positive
but less than the trigger cash proportion multiplied by
the account value, then this balance is within
allowable cash limits. Hence, execution exits from
routine 1000 via YES path 1012 emanating from decision
block 1010. Alternatively, if the cash balance exceeds
the trigger cash proportion multiplied by the account
value, then the account contains excess cash. Hence,
decision block 1012 routes execution, via NO path 1014,
to block 1015. This latter block initializes the value
of index variable i to one.
At this point, execution enters a loop
containing blocks 1020, 1025, 1030 and 1035 to
calculate a remainder trade, ~i, for each security in
the account, i.e. in SECURITY_SET. A remainder trade
is an amount of each security in the portfolio that
could be traded to consume or raise cash. Once a set of
these trades have been calculated, one or more of the
trades in this set will be selected, in seriatim, to
consume or raise as much cash as needed to make the
cash balance in the account, on a proportionate basis,
positive but less than the cash maintenance proportion,
C.
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Specifically, upon entry into this loop,
execution proceeds to block 1020 to select the next
successive security in SECURITY SET, i.e. SECURITY(i).
Once this has occurred, execution proceeds to block
1025 to calculate a remainder trade for this particular
security. This remainder trade, 8;,, is initially
calculated as the target proportion for this security,
multiplied by the account value, V, less the
current share price, pi, of this security multiplied by
the number of shares, ai, held in this security. This
remainder trade will be set to zero if any of the
following conditions is satisfied for this security:
(a) the number of shares that has just been calculated
to be traded, Ei, is non-zero; (b) the current
proportion is already less than the target proportion;
or (c) it is proscribed or is posted ox already has a
trade-pending therefor.
Once block 1025 has completely executed to
generate an appropriate remainder trade for
SECURITY(i), decision block 1030 executes to determine
whether all securities in the set have been selected,
i.e. whether the current value of index variable i
equals the value of variable m. If a security in this
set remains to be selected, then decision block 1030
routes execution, via NO path 1032, to block 1035.
This latter block increments the current value of index
variable i by one in order to point to a next
successive security in the set. Execution then loops
back, via path 1038, to block 1020 to appropriately
process that security, and so forth. Alternatively, if
all the securities in the set have been so processed,
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then execution proceeds to decision block 2040, via YES
path 1034 emanating from decision block 1030.
At this point, execution enters a loop
containing blocks 1040, 1045, 1050, 1055, 1060 and 1065
to select the largest remainder trade(s), in seriatim,
to, e.g., consume all the excess cash, i.e. until the
cash balance falls within the cash maintenance
proportion, C, multiplied by the account value.
In particular, within this loop, execution
first proceeds to decision block 1040 to test whether
the cash balance, K, is negative or exceeds the cash
maintenance proportion, C, multiplied by the account
value. If the cash balance is positive but less than
this maintenance proportion multiplied by the account
value, then no further trades need to be issued to
consume cash. Accordingly, execution exits from
routine 1000, via NO path 1042 emanating from decision
block 1040. Alternatively, if the current cash
balance, K, as a result of a prior iteration through
this loop, is negative or greater than the cash
maintenance proportion, C, multiplied by the account
value, then decision block 1040 routes execution, via
YES path 1044, to block 1045. This latter block
determines the amount of excess portfolio cash, D, that
needs to be consumed or raised (in the event this
parameter is negative). Excess cash is simply
determined as being the current cash balance, K, in _
the account less the cash maintenance proportion, C,
multiplied by the current value of the account, V.
Once this determination is made, execution proceeds to
block 1050 to select the particular remainder trade to
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issue as a trade from the set of remainder trades that
has just been determined. If the excess cash is
positive, then the particular remainder trade that is
selected from the set is that which involves the
largest security purchase, in monetary terms. Else, if
the excess cash balance is negative, indicating that
cash needs to be raised, then the particular remainder
trade that is selected from the set of remainder trades
is that which involves the largest sale, again in
monetary terms. The amount of the resulting selected
remainder trade, denoted 6k, is then adjusted through
execution of block 1055. In particular, in the event
this remainder trade would consume more than the excess
cash, then this block reduces this remainder trade to
consume just this amount of cash. Thereafter,
execution proceeds to block 1060 to determine the
number of shares to be traded through this particular
remainder trade. This number,sk, is initially
calculated through equation (9) as follows:
8k
s k = 100 Int 100 ( 9 )
pk
Once this number is determined, then the remainder
trade for this security, i.e. 8k, is set equal to zero
to eliminate any remainder trade for this security from
further selection. Thereafter, if the remainder trade,
_ when combined with the number of shares currently in
this security, would result in a short sale, i.e. the
remainder trade involves a sale of more shares than
currently held in this security, i.e. ai, then the
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number of shares to be sold through this particular
remainder trade, i.e. sk, is reduced to the number of
shares currently held. The trade type for this trade,
vk, is set to °'C" to reflect this trade as a cash
control trade. Once block 1060 has fully executed to
complete the generation of the appropriate remainder
trade, then execution proceeds to block 1065 to update
the portfolio value and cash balance to reflect this
remainder trade. Specifically, block 1065 updates the
cash balance by first calculating the total cost, y,
associated with the current trade. This cost is
illustratively calculated as being the assumed trading
cost ($ .15/sharej multiplied by the number of shares
to be traded. As noted above in connection with
block 945, other cost metrics, such as a flat or
sliding fee, can be used instead, if and when
appropriate. In any event, once the trade cost is
determined through block 1065, this block then updates
the current cash balance, K, as simply the prior cash
balance less number of shares to be traded multiplied
by their price per share less the trade cost. Lastly,
the portfolio value, V, is updated by simply
subtracting the trade cost, y, and the remainder trade
is inserted into the trading list. Once this occurs,
execution loops back, via path 1068, to decision
block 1040 to determine whether any further remainder
trades need to be selected, and so forth.
FIG. 11 depicts table 1100 which provides,
for purposes of comparison, abbreviated S & P 500 data
and simulated corresponding numerical data, the latter
generated through use of my present invention using S &
P 500 data at two exemplary successive dates spaced
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apart by one week: the close of the market on June 28,
1996 and on July 5, 1996. Though the preferred
embodiment manages holdings in all 500 securities on
the S & P 500 index (with exception of those that are
' 5 proscribed, as discussed above), for purposes of
simplified illustration, this figure merely shows
tabular data for 14 well-known and large corporations
in the S & P 500 index.
Column 1110 provides the security name, with
the ticker symbol for each corresponding security
listed in column 1120. For June 28, 1996 and July 5,
1996, columns 1130 and 1160, respectively, list the
closing market share prices for each of these
securities. The S & P 500 capitalization weightings
for each of these securities as it existed on June 28,
1996 and on July 5, 1996 are listed iri columns 1140 and
1170. Lastly, columns 1150 and 1180 provide the
weightings for each of these securities as determined
for each of these two dates through my inventive
dynamic rebalancing methodology, as discussed above
with specific reference to FIGS. 6A-10B. Changes can
be readily seen in both the S & P 500 weightings and in
my corresponding dynamic rebalancing weightings
determined for the closing share prices on these two
dates.
Furthermore, for comparative performance over
a relatively long perspective and as noted above, I
have found, through empirical analysis, that setting
the value of diversity exponent p equal to .76 produces
a portfolio that consistently yields, over a simulated
16 year test interval an annual return that exceeds
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that of the S & P 500 index by approximately 40-50
basis points (bp).
In particular, to assess the relative
performance of my inventive methodology, I have
simulated the performance of that methodology with 16
years of actual market data, from 1979 to 1995, and
have compared the results to two other major market
indices, namely the S & P 500 index and the Russell
1000 index. The latter is similar to the S & P 500
index with the difference being that Russell 1000 index
contains the top 1000, rather than 500, securities in
terms of market capitalization - hence being more
weighted to securities with relatively low market
capitalizations. I have chosen to start with 1979
market data inasmuch as that year coincides with the
inception of the Russell 1000 index.
FIG. 12 depicts, in graphical form, resulting
simulated performance data for my present invention,
along with actual performance data for the S & P 500
and Russell 1000 indices for the period 1979-1995, with
corresponding annualized returns and associated
standard deviation being shown in tabular form in
FIG. 13. As can be seen, the simulated performance of
my dynamic rebalancing methodology would have
consistently tracked both the S & P 500 and Russell
1000 indices over this 16 year period and would have
generated an annual return which advantageously
exceeded that of both indices by approximately 40-50 by _
and with less variability than that associated with
either of these two indices.
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Clearly those skilled in the art realize that
the present invention can be simultaneously employed to
' dynamically rebalance equity holdings in an index fund
reflective of several different, e.g., national based,
capitalization weighted indices, one of which can
illustratively be the S & P 500 index as discussed
above with others for, e.g., different countries or
regions. The weighting of each individual security
that constitutes any one of the indices would be
dynamically changed as needed, independent of each of
those that constitute any of the other indices, as a
result of a non-constant function of current
capitalization weightings of that one index. These
separate national (or regional) indices can then be
combined to form a single international index, with
each national (or regional) index being separately
managed in the manner taught by the present invention.
Furthermore, the present invention can be
utilized in conjunction with an international index
that uses financial derivatives to, e.g., replicate or
even improve the returns of the underlying national
indices. Inasmuch as so-called "swap" contracts may
have a favorable tax treatment in some countries over
owning the underlying equity securities, these (and/or
other related forms of) derivatives could he held in
the same weights as would the corresponding equity
securities. Similarly, so-called "futures" and certain
options could be held and managed in lieu of
corresponding equity securities. In addition, hybrid
strategies combining equities, derivatives, futures
and/or options in some manner can be utilized with
their management, within an index fund, occurring in
accordance with my present invention.
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Specifically, the present invention can be
utilized in conjunction with "put" and "call" options.
Here, once an appropriate weight has been calculated
for each security in an index fund, transaction orders,
such as for the purchase or sale of common stock (as
described above in the context of the preferred
embodiment), are issued, as needed, to properly
rebalance the entire portfolio to reflect all the new
weightings. In lieu of purchasing or selling just
shares of common stock, the order, in lieu thereof or
additionally, could involve the purchase or sale of
options, e.g. puts or calls, on that stock. Such
options would be financially equivalent to all or a
portion of the number of shares of the underlying
common stock to be traded, as determined through
dynamic rebalancing. Inasmuch as the value of such
options dynamically changes their share equivalence as
the price of the underlying stock changes, these
variations could be exploited to assist in dynamically
rebalancing the portfolio. Nevertheless, at a moment a
trade is executed, the share equivalent of the mixture
of stock shares and options would match the number of
shares in a pure stock transaction.
In addition, foreign equities trade on
various United States exchanges through so-called
"American Depository Receipts" (ADRs) each of which
represents ownership, in some fraction, of a share of
an underlying foreign common stock. Inasmuch as it is
easier and often less expensive, from a transaction _
cost perspective, to trade in ADRs through a US
exchange than in shares of the corresponding foreign _
stock through a foreign exchange, ADRs or some form of
financial instrument, such as derivative(s), futures or
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options, based thereon, which are financially
equivalent to actual shares of common stock, could be
' substituted as all or part of a transaction originally
denominated in shares of the foreign stock.
S
Although a single embodiment, in terms of
apparatus and methods, which incorporates the teachings
of the present invention, as well as various
modifications and extensions thereof, has been shown
and described in detail herein, those skilled in the
art can readily devise many other varied embodiments,
modifications and/or extensions that still incorporate
these teachings.
