Engineering Applications of Artificial Intelligence 100 (2021) 104154

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Engineering Applications of Artificial Intelligence

journal homepage: www.elsevier.com/locate/engappai

A new interval type-2 fuzzy logic system under dynamic environment:

Application to financial investment
Akihiko Takahashi a ,∗, Soichiro Takahashi b
a
Faculty of Economics, University of Tokyo, 7-3-1 Hongo Bunkyo-ku, Tokyo, 113-0033, Japan
b
GCI Asset Management, 10F, Chiyoda First Building East, 3-8-1 Nishi Kanda, Chiyoda, Tokyo, 101-0065, Japan

ARTICLE INFO ABSTRACT

Keywords: This paper proposes a new interval type-2 fuzzy logic system (IT2 FLS) for financial investment with time-
Interval type-2 fuzzy logic system varying parameters adaptive to real-time data streams by using an on-line learning method based on a
Sequential learning state-space framework. Particularly, our state-space approach regards the parameters of IT2 FLSs as state
State space model
variables to sequentially learn by Bayesian filtering algorithms under dynamic environments, where time-series
Particle filtering
data are continuously observed with occasional structural changes. Moreover, our proposal is effective for
Financial investment
financial investment, which often involves various practical complex constraints, because general state-space
model makes it possible to flexibly deal with non-linearities. In our empirical experiment with time-series data
of global financial assets, our approach is applied to on-line parameter learning of type-1 and type-2 FLSs for
portfolio decision making. As a result, it is shown that the IT2 FLS holds its advantage against the type-1 FLS,
even though both of the type-1 and type-2 models have the adaptive time-varying parameters, which is an
unexplored topic for empirical studies of this area.

1. Introduction
Financial markets are well-known to be highly complex and non-
linear systems with noise, which are affected by economic, political,
geopolitical, and psychological factors. Recently, in that financial deci-
sion making, artificial intelligence (AI) techniques have been increas-
ingly used in both academia and industry, because they are effective to
deal with non-linearity or uncertainty. Specifically, a fuzzy logic system
(FLS) stores multiple IF-THEN inference rules with linguistic expres-
sions, i.e. fuzzy sets (FSs) introduced by Zadeh (1965), which enables
to imitate human expert reasoning within a computer. In particular,
Mamdani and Assilian (1975) and Takagi and Sugeno (1985) have de-
veloped benchmark FLSs as pioneers. Since the qualitative and intuitive
explanation of a decision to stakeholders is an important task, FLSs are
appropriate for decision making in financial investment. For instance,
professional fund managers, or financial investment experts, are usually
required to clarify the reasons for their decisions to investors.
In particular, type-2 FLSs, explored by Karnik and Mendel (1998)
and Karnik et al. (1999), have drawn much attention, because they are
extensions of type-1 FLSs in terms that FSs have membership functions
(MFs) whose values are themselves fuzzy, i.e., the so-called type-2 FSs
introduced by Zadeh (1974). As pointed out in Mendel and John (2002)
and Wu and Mendel (2002), type-2 FLSs make it possible to resolve
uncertainties in type-1 FLSs by utilizing type-2 FSs instead of type-
1 FSs. Since then, the effectiveness of type-2 fuzzy models has been
shown in various application fields. For instance, Karnik and Mendel
(1999) demonstrated the superiority of a type-2 FLS compared with a
type-1 model in numerical experiments for predictions using simulated
chaotic time-series data. Also, Castillo et al. (2016b) presented the
advantage of generalized type-2 (GT2) FLSs against type-1 FLSs and
interval type-2 FLSs in four benchmark control problems. Besides,
Ontiveros-Robles et al. (2018) showed a comparison in the robustness
of interval type-2 and GT2 fuzzy logic controllers (FLCs), to generate
criteria to decide which type of controller was better in specific ap-
plications. Further, Hagras (2004) presented a novel reactive control
architecture for autonomous mobile robots based on type-2 fuzzy logic
controllers. Moreover, Sepulveda et al. (2007) dealt with the design
of control systems using type-2 fuzzy logic for minimizing the effects
of uncertainty, where both experimental results on a feedback control
system for a non-linear plant and time-series prediction showed the
advantage to type-1 models. In contrast, Birkin and Garibaldi (2009)
reported that in controlling a robot DC motor model there was no
statistical difference between type-1 and type-2 FLCs.
In this paper, we will use interval type-2 (IT2) FLSs, developed in
Liang and Mendel (2000) or Mendel (2001). Since the general type-
2 FLS is computationally intensive, the simplicity of IT2 FLSs has
been beneficial for real-time control problems, as pointed out in Liang
and Mendel (2000). In particular, this paper proposes a new IT2 FLS
for financial portfolio investment, whose parameters are sequentially

∗ Corresponding author.
E-mail addresses: akihikot@e.u-tokyo.ac.jp (A. Takahashi), souichiro.takahashi@gci.jp (S. Takahashi).

https://doi.org/10.1016/j.engappai.2021.104154
Received 12 February 2020; Received in revised form 3 November 2020; Accepted 2 January 2021
Available online 13 January 2021
0952-1976/© 2021 Elsevier Ltd. All rights reserved.
A. Takahashi and S. Takahashi
learned by a state-space approach. More concretely, the parameters
of IT2 FLS are interpreted as unobservable time-varying state vari-
ables, where Bayesian filtering implements on-line state estimation.
In other words, our proposed IT2 FLS is continuously adjusted to the
environmental changes through sequential information updating by
filtering implementation. The reason why we consider IT2 FLS with
time-varying parameters is the necessity to deal with environmental
changes in financial markets. Namely, global news or events often
cause a fundamental change in market dynamics, leading to a different
pattern of transitions in asset prices or foreign exchange rates. Thereby,
FLSs with fixed rules and parameters learned over a fixed period do not
necessarily work well, after market conditions totally change from the
learning period. For example, the performance of FLSs learned under a
trended market would deteriorate in a range market, where asset prices
repeat climbing and declining.
Therefore, from our point of view, there are two approaches or
dimensions to enhance the ability of standard type-1 FLSs under time-
varying environments such as financial markets, both of which extend
the degree of freedoms of type-1 FLS in different directions:
(i) Sequential adjustment of rules or parameters in FLSs.
(ii) The introduction of type-2 FSs or type-2 FLSs.
Particularly, the main contribution of this paper is the introduction
of type-2 FLS, i.e. the dimension (ii), in financial investment decision.
That is, it is an empirically unexplored topic that even if the parameters
of FLSs are sequentially learned to be time-varying, type-2 modeling
still holds its advantage against type-1 FLSs. We answer to this prob-
lem by showing with empirical data of global financial assets that
proposed IT2 FLSs robustly outperform type-1 models in investment
decision-making problems for several important performance measures.
Especially, we implement a statistical comparison on Sharpe ratios (in
Section 6.2), one of the most critical performance measures, to confirm
the robustness of the investment results. Further, in Section 6.3 we also
discuss the reasons why our IT2 FLSs outperform the type-1 FLSs.
Also, although there are existing researches on time-varying IT2
FLSs as shown in the next Section 2, its general realization under the
state-space framework is the first attempt to the best of our knowledge.
Let us note that the relative strength of our approach to the previous re-
searches is its generality. In other words, since our proposal formulates
the FLS learning problem under the general state-space framework,
flexible problem specifications are possible. Especially, non-linear fil-
tering algorithms such as Monte Carlo simulation-based methods such
as particle filters (PFs) are effective to solve those problems. This ad-
vantage is particularly helpful for financial decision making, which in-
volves various practical constraints, often mathematically represented
in non-linear equations/inequalities. As shown in Section 5.2, several
standard portfolio constraints easily associate with non-linear equa-
tions/inequalities including non-differentiable terms such as absolute
values, which might make it difficult to apply the existing learn-
ing methods dependent on derivatives such as fuzzy neural network
approaches.
The remainder of this paper is organized as follows: After Sec-
tion 2 discusses the related works, Section 3 states preliminary, which
introduces a state space framework to learn IT2 FLSs in a general
setting. Then, after Section 4 presents our IT2 FLS for financial portfolio
construction, Section 5 shows a total scheme of our proposal. Moreover,
Section 6 shows our empirical experiments, where investment simula-
tions with our FLSs are implemented by using global financial assets.
Finally, Section 7 concludes.
2. Related works
There are various existing researches on the learning of their rule-
base or parameters. From our point of view explained in Section 1,
there are four patterns in the FLS learning problems:
(i) Type-1 fuzzy model & fixed parameters/rules
2
Engineering Applications of Artificial Intelligence 100 (2021) 104154
(ii) Type-1 fuzzy model & time-varying parameters/rules
(iii) Type-2 fuzzy model & fixed parameters/rules
(iv) Type-2 fuzzy model & time-varying parameters/rules
As pointed out in Section 1, the current work is to attempt the pattern-
(iv).
For the pattern-(i), there are numerous works: For example, genetic
algorithms (Holland, 1992) is helpful for the optimal rule generation
and parameter learning, i.e. the so-called genetic fuzzy system, devel-
oped by Michael and Takagi (1993), Herrera and Verdegay (1996), and
Cordon et al. (2001). Also, neuro-fuzzy or neural FLS has been widely
accepted as one of the most effective approaches, where learning
algorithms of neural network has been utilized for the identification
of FLSs (Jang, 1993; Jang and Sun, 1995; Ouyang et al., 2005).
With regard to the pattern-(ii), i.e. type-1 FLSs under the dynamic
environment, evolving fuzzy approaches (Kasabov and Song, 2002;
Angelov and Filev, 2004) are well-known, in which a rule base and
parameters continually evolve to match the current information from
new data arrival. For the evolving fuzzy models, there are some finan-
cial applications researches. More concretely, the evolving FLS consists
of two procedures, i.e. the cluster learning to specify the FSs in the
antecedent part of the fuzzy inference and the parameter learning in the
consequent part. There exist several empirical examples that tackled the
financial applications of evolving FLSs (Maciel et al., 2012, 2014). Also,
Nakano et al. (2019) has implemented an adaptive learning method in
type-1 FLSs for financial portfolio construction.
As for the pattern-(iii), the learning of time-invariant parameters or
structure in type-2 FLSs has also been investigated in various papers.
Melin and Castillo (2002) described adaptive model-based control of
non-linear plants using type-2 FLS with a neuro-fuzzy approach to learn
the parameters of the FLS. Lee et al. (2003) presented a type-2 fuzzy
neural network system (type-2 FNN) with a back-propagation-based pa-
rameter learning algorithm, where the previous research on type-1 FNN
was extended to type-2 one. Also, Wang et al. (2004), later modified
by Hagras (2006), proposed an interval type-2 FNN (IT2FNN) with two-
layer neural networks in the consequent part, which was applied to the
truck backing-up control, yielding more improved performance than
type-1 FNN. Further, Mendez and Castillo (2005) showed a new FNN-
based hybrid learning algorithm for IT2 FLS. That is, in the forward
pass, the FLS output was calculated and the consequent parameters
are estimated by recursive least-squares and square-root filter methods,
while the antecedent parameters are estimated in the backward pass.
Besides, Castro et al. (2009) proposed three interval type-2 fuzzy neural
network (IT2FNN) architectures with hybrid learning algorithm tech-
niques. Moreover, Wang and Kumbasar (2019) applied big bang-big
crunch (BBBC) optimization and particle swarm optimization (PSO) to
the parameter learning of IT2FNNs, which could eliminate the need for
back-propagation computation. Concerning the application to finance,
Zarandi et al. (2009) developed IT2 FLS for stock price prediction
with technical and fundamental indexes as input variables, where
experimental tests showed successful forecasting results.
Apart from those FNN researches, which depend on the derivatives
of functions used in the systems, there are also derivative-free learning
algorithms, as is the same for type-1 learning. For instance, Khanesar
et al. (2011) made use of an extended Kalman filter, while Olivas et al.
(2016, 2017) utilized evolutionary calculation such as particle swarm
optimization and ant colony optimization, respectively. In addition,
Castillo et al. (2016a) proposed a granular approach for intelligent
control using generalized type-2 fuzzy logic, where a complex global
controller is divided into several individual simpler controllers.
Finally, let us introduce the pattern-(iv) researches, i.e. type-2 FLS
with dynamic parameters/rules. Juang and Tsao (2008) proposed a
self-evolving interval type-2 fuzzy neural network (SEIT2FNN) with
online structure and parameter learning, where as well as gradient
descent, rule-order Kalman filter was exploited to avoid rule reordering
problems. Also, Bouchachia and Vanaret (2013) presented a Grow-
ing Type-2 Fuzzy Classifier (GT2FC), in which a new semi-supervised
online learning algorithm called Growing Gaussian Mixture Model
(2G2M) was developed.
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

3. Preliminary: State space framework for FLS learning
First of all, this paper considers the following adaptive learning
problem of FLSs for portfolio investment: For each time 𝑡 ∈ {1, … , 𝑇 },
input variables 𝑋𝑡 are fed into FLS represented by a mathematical
function 𝑌𝑡 = 𝐹 (𝑋𝑡 ; 𝑍𝑡 ) to calculate a portfolio weight 𝑌𝑡 , where 𝑍𝑡
are time-varying parameters in the FLS. Here, by using a state-space
model with Bayesian filtering algorithms, the parameters 𝑍𝑡 are sequen-
tially estimated as unobservable state variables. In particular, under
a state space model that consists of state and observation equations
in general, the transition of time-varying parameters 𝑍𝑡 are described
by state equations, whilst the performance evaluation at each time 𝑡 is
implemented by observation equations.
That is, our learning problem is formulated under the following
state space model:
𝑂𝑡 = 𝐻(𝑌𝑡 , 𝑢𝑡 ),
𝑌𝑡 = 𝐹 (𝑋𝑡 ; 𝑍𝑡 ),
𝑍𝑡 = 𝐺(𝑍𝑡−1 , 𝑣𝑡 ).
Let us remark that for a given input data of FLS 𝑋𝑡 and observation
variables 𝑂𝑡 , Eqs. (1) and (2) can be regarded as observation equations
in a state space model. Also, Eq. (3) is a state equation, describing the
time transition of state variables 𝑍𝑡 . Thus, the system of equations,
Eq. (1)–(3), form a state-space model. Let us remark that a general state
space model with particle filter is explained in Appendix.
Behind this formulation, the next situation is assumed: First of all, a
designer of FLSs under the dynamic environment has the motivation to
know which identification will perform the best, though it is unknown
in advance. Then, based on the assumption that the optimal FLS iden-
a given parameters 𝑍. Motivated by the limitation for type-1 FSs to
represent the effect of uncertainties, type-2 FSs have been attracting
interests, which are characterized by membership functions (MFs) that
are themselves fuzzy. Especially, in an IT2 FS 𝐴, the MF value for each
crisp input value 𝑥 is an interval [𝑎, 𝑎], meaning that it is bounded from
the above and below by two T1 FSs 𝐴 and 𝐴. Let us remark that the
MFs of those T1 FSs 𝐴 and 𝐴 are called an upper MF 𝜇𝐴 and a lower
MF 𝜇𝐴 , respectively.
Specifically, our IT2 FLS 𝐹 (⋅; 𝑍) ∶ R𝐾×𝐼×𝑁 → R𝑁 has input data
𝑋 = (𝑥𝑘,𝑖,𝑛 )𝑘,𝑖,𝑛 ∈ R𝐾×𝐼×𝑁 and an output vector 𝑌 = (𝑦𝑛 )𝑛 ∈ R𝑁 , where
𝑥𝑘,𝑖,𝑛 denotes the 𝑖th technical indicator in the 𝑘th IF-THEN rule for the
𝑛th asset, while 𝑦𝑛 stands for the output for the 𝑛th asset. Then, the 𝑘th
IF-THEN rule for the 𝑛th asset is described as follow (𝑘 = 1, … , 𝐾):
IF (𝑥𝑘,1,𝑛 is 𝐴𝑘,1 ) AND ⋯ AND (𝑥𝑘,𝐼,𝑛 is 𝐴𝑘,𝐼 ), THEN 𝑦𝑛 is 𝐵𝑘 .
(1)
Here, (𝐴𝑘,𝑖 )𝑘,𝑖 are IT2 FSs and 𝐵𝑘 = [𝑏𝑘 , 𝑏𝑘 ] ⊂ R. We note that in our
(2) empirical experiment, 𝐾, 𝐼 and 𝑁 stand for the number of IF-THEN
(3) rules, inputs and investment assets, respectively.
Now, following the previous literature (Wu, 2010), let us explain a
typical calculation procedure of IT2 FLSs with 𝐾 number of IF-THEN
rules of the 𝑖th technical indicator (𝑖 = 1, … , 𝐼) for each 𝑛th asset’s input
matrix 𝑥𝑛 ∶= (𝑥𝑘,𝑖,𝑛 )𝑘,𝑖 ∈ R𝐾×𝐼 :
(i) Compute the UMF and LMF values for 𝑥𝑘,𝑖,𝑛 , i.e. (𝜇𝐴 (𝑥𝑘,𝑖,𝑛 ), 𝜇𝐴
𝑘,𝑖 𝑘,𝑖
(𝑥𝑘,𝑖,𝑛 )), 𝑘 = 1, … , 𝐾, 𝑖 = 1, … , 𝐼.
(ii) Compute the firing strength of the 𝑘th rule, 𝐹 𝑆𝑘 (𝑥𝑛 ) ⊂ R for
𝑘 = 1, … , 𝐾.
[ 𝐼 ]
∏ ∏𝐼

tification can change over time, the designer attempts to estimate their 𝐹 𝑆𝑘 (𝑥𝑛 ) ∶= 𝜇𝐴 (𝑥𝑘,𝑖,𝑛 ), 𝜇𝐴 (𝑥𝑘,𝑖,𝑛 )
𝑘,𝑖 𝑘,𝑖
𝑖=1 𝑖=1 (4)
transitions through periodical performance measurements. [ ]
This situation is described by the state space representation in ≡ 𝑓 , 𝑓 𝑛,𝑘
𝑛,𝑘
Eq. (1)–(3) as follows: First, the dynamic transitions of optimal param-
eters are formulated by the state equation Eq. (3). Then, the FLS Eq. (2) (iii) The following center-of-sets (COS) type-reducer 𝑓𝐶𝑂𝑆 generates
is applied to the input variables 𝑋𝑡 for the model parameters 𝑍𝑡 given the corresponding rule consequents by combining (𝐹 𝑆𝑘 (𝑥𝑛 ))𝑘 .
by the state equation Eq. (3), which generates the output variables ∑𝐾
⋃ 𝑘=1 𝑓𝑘 𝑦𝑘
𝑌𝑡 . Moreover, the observation equation Eq. (1) expresses performance 𝑓𝐶𝑂𝑆 (𝑥𝑛 ) ∶= ∑𝐾
measurement based on the information available at time 𝑡 with some 𝑓𝑘 ∈𝐹 𝑆𝑘 (𝑥𝑛 ), 𝑦𝑘 ∈𝐵𝑘 𝑘=1 𝑓𝑘
(5)
uncertainty or noise. [ ]
= 𝑦𝑛,𝑙 , 𝑦𝑛,𝑟
Based on the above state space representation, our PF algorithm
is implemented as follows: First, it generates various candidates of It has been shown that
model’s parameters based on the state equation, and then selects well- ∑ 𝑘∗ ∑𝐾
𝑘=1 𝑓 𝑛,𝑘 𝑏𝑘 + 𝑘=𝑘∗ +1 𝑓 𝑛,𝑘 𝑏𝑘
performing ones from the measurement by the observation equation. 𝑦𝑛,𝑙 = ∗ min ∑ ∗ ∑
𝑘 ∈[1,𝐾−1] 𝑘 𝐾
Let us remark that PF makes it possible to apply our approach to 𝑘=1 𝑓 𝑛,𝑘 + 𝑘=𝑘∗ +1 𝑓 𝑛,𝑘
various kinds of learning problems, because it allows non-linear and ∑𝐿 ∑𝐾
𝑘=1 𝑓 𝑛,𝑘 𝑏𝑘 + 𝑘=𝐿+1 𝑓 𝑛,𝑘 𝑏𝑘
non-Gaussian settings. = ∑𝐿 ∑𝐾
𝑘=1 𝑓 𝑛,𝑘 + 𝑘=𝐿 𝑓 𝑛,𝑘
4. Proposed IT2 FLS for portfolio construction ∑ 𝑘∗ ∑𝐾 (6)
𝑘=1 𝑓 𝑛,𝑘 𝑏𝑘 + 𝑘=𝑘∗ +1 𝑓 𝑛,𝑘 𝑏𝑘
𝑦𝑛,𝑟 = ∗ max ∑ 𝑘 ∗ ∑ 𝐾
This section introduces our proposed IT2 FLS for portfolio con- 𝑘 ∈[1,𝐾−1]
𝑘=1 𝑓 𝑛,𝑘 + 𝑘=𝑘∗ +1 𝑓 𝑛,𝑘
struction, that is, the specification of Eq. (2)𝑌𝑡 = 𝐹 (𝑋𝑡 ; 𝑍𝑡 ). Precisely, ∑𝑅 ∑𝐾
Section 4.1 first introduced our IT2 FLS for given input variables 𝑘=1 𝑓 𝑛,𝑘 𝑏𝑘 + 𝑘=𝑅+1 𝑓 𝑛,𝑘 𝑏𝑘
= ∑𝑅 ∑𝐾
and fuzzy IF-THEN rules including IT2 FSs and their MFs, which are + 𝑘=𝑅+1 𝑓 𝑛,𝑘
𝑘=1 𝑓 𝑛,𝑘
specified in Section 4.2. Let us notice that in Section 4.1 the time
indexes 𝑡 ∈ {1, … , 𝑇 } are omitted for simple notation. where the switch points 𝐿 and 𝑅 satisfy
𝑏𝐿 ≤ 𝑦𝑛,𝑙 ≤ 𝑏𝐿+1 ,
4.1. Interval type-2 fuzzy logic system (7)
𝑏𝑅 ≤ 𝑦𝑛,𝑟 ≤ 𝑏𝑅+1 ,
In this section, we introduce our IT2 FLS, i.e. a non-linear real-
and (𝑏𝑘 )𝑘 and (𝑏𝑘 )𝑘 are sorted in ascending order. Then, the
valued function 𝑌 = 𝐹 (𝑋; 𝑍), Eq. (2) in Section 3. As introduced
𝑦𝑛,𝑙 and 𝑦𝑛,𝑟 are calculated using Karnik-Mendel (KM) algorithms
in Section 3, 𝑋, 𝑌 and 𝑍 stand for inputs, outputs and parameters
(Karnik and Mendel, 2001).
of IT2 FLS, respectively, where the time indexes 𝑡 ∈ {1, … , 𝑇 } are
(iv) Compute the defuzzified output as follows:
omitted for simple notation. In particular, our IT2 FLS 𝐹 for financial
investment decision provides proper portfolio weights 𝑌 from technical 𝑦𝑛,𝑙 + 𝑦𝑛,𝑟
𝑦𝑛 = . (8)
indicators 𝑋 of financial assets through a rule-based inference under 2

3
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

One of the most important issues with FLS applications is how to (r-4) IF
decide the parameters. Especially, the parameters in consequent parts (20,60)-days MACD is 𝐴4,1 AND
of IT2 FLS, i.e. (𝑏𝑘 , 𝑏𝑘 )𝑘 in the above example, have critical impact not (20,120)-days MACD is 𝐴4,2 AND
only on the performance but also on the characteristics of inference. (40,60)-days MACD is 𝐴4,3 AND
Therefore, those parameters (𝑏𝑘 , 𝑏𝑘 )𝑘 are regarded as state variables 𝑍𝑡 (40,120)-days MACD is 𝐴4,4 ,
to be sequentially estimated under our state space framework. THEN
portfolio weight is in [𝑏4 , 𝑏4 ] ⊂ R.

4.2. Specification of proposed IT2 FLS Here, we note that the input variables (𝑥𝑘,𝑖,𝑛,𝑡 ) at time 𝑡 are specified as
follows.
In previous Section 4.1, we have concretely explained a func- (𝑥𝑘,𝑖,𝑛,𝑡 )𝑖=1,…,4
tion 𝐹 (𝑋; 𝑍), i.e. IT2 FLS, for given technical indicator inputs 𝑋 = ⎧
(𝑥𝑘,𝑖,𝑛 )𝑘,𝑖,𝑛 ∈ R𝐾×𝐼×𝑁 and given MFs of IT2 FLS, (𝜇𝐴 (𝑥𝑘,𝑖,𝑛 ), 𝜇𝐴 (𝑥𝑘,𝑖,𝑛 )), ⎪(𝑒20 , 𝑒40 , 𝑒60 , 𝑒120 ), 𝑘 = 1, 2, (11)
𝑘,𝑖 𝑘,𝑖 = ⎨ 𝑛,𝑡 𝑛,𝑡 𝑛,𝑡 𝑛,𝑡
which will be specified in this section. ⎪(𝑒(20,60) , 𝑒(20,120) , 𝑒(40,60) , 𝑒(40,120) ), 𝑘 = 3, 4.
⎩ 𝑛,𝑡 𝑛,𝑡 𝑛,𝑡 𝑛,𝑡
Namely, the inputs 𝑋𝑡 , parameters 𝑍𝑡 and outputs 𝑌𝑡 of IT2 FLS in
Eq. (2) correspond to the technical indicators of trading instruments Here, the linguistic meanings of IT2 FSs (𝐴1,𝑖 )𝑖=1,…,4 and (𝐴3,𝑖 )𝑖=1,…,4 are
(𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 ∈ R𝐾×𝐼×𝑁 , the parameters (𝑏𝑘,𝑡 , 𝑏𝑘,𝑡 )𝑘 ∈ R2×𝐾 in the conse- high, while those of (𝐴2,𝑖 )𝑖=1,…,4 and (𝐴4,𝑖 )𝑖=1,…,4 are low. Importantly,
quent part of the IF-THEN rules, and portfolio weights (𝜔𝑛,𝑡 )𝑛 ∈ R𝑁 at this rulebase implies that a portfolio weight for an investment asset is
decided whether EMAs/MACDs are high/low for all the periods (𝑖 =
time 𝑡, respectively, where the indexes 𝑘 = 1, … , 𝐾, 𝑛 = 1, … , 𝑁 and
1, … , 4), which aims to capitalize the price change patterns in the so-
𝑖 = 1, … , 𝐼 stand for the IF-THEN rules, investment assets and technical
called trend and range markets. For instance, since a high EMA value of
indicators.
an asset imply up-trended price movements, it may be effective to buy
The technical indicators that will be used in this paper are ex- this asset. Also, when MACD of an asset is low, it may be recommended
ponential moving average (EMA) and moving average convergence to sell it, because low MACD is often interpreted as the end of up-
divergence (MACD). Especially, given daily rates of returns data flow trended price movements and the beginning of price decrease. Here let
(𝑟𝑛,𝑑 )𝑑 for the 𝑛th asset, 𝑚-days EMA 𝑒𝑚 𝑛,𝑑
and (𝑚1 , 𝑚2 )-days MACD us notice that by using the four periods of EMAs/MACDs (𝑖 = 1, … , 4),
(𝑚 ,𝑚2 )
𝑒𝑛,𝑑1 at date 𝑑 are defined as follows: only robust price change patterns are utilized.
As shown in Section 3, the parameters (𝑏𝑘 , 𝑏𝑘 )𝑘 ∈ R2×𝐾 are regarded
• Exponential Moving Average (EMA) 𝑒𝑚
𝑛,𝑑 as time-varying state variables (𝑧𝑘,𝑡 )𝑘 ∶= (𝑏𝑘,𝑡 , 𝑏𝑘,𝑡 )𝑘 ∈ R2×𝐾 , which are
adaptively learned under the state space framework. That is, when 𝑧1,𝑡
𝑒𝑚 𝑚 𝑚 𝑚
𝑛,𝑑 = 𝛽 𝑟𝑛,𝑑−1 + (1 − 𝛽 )𝑒𝑛,𝑑−1 , (9)
and 𝑧3,𝑡 are estimated to be higher values than 𝑧2,𝑡 and 𝑧4,𝑡 , respectively,
where the parameter 𝛽𝑚 is called a decaying parameter that rep- our model proposed to take long (𝑟𝑒𝑠𝑝. short) positions for the assets
resents the degree of weighting decrease. Especially, we specify with high (𝑟𝑒𝑠𝑝. low) EMA or MACD, showing strong uptrend (𝑟𝑒𝑠𝑝.
𝛽𝑚 = 2∕(1 + 𝑚) for an integer 𝑚, which is usually referred to as downtrend).
𝑚-period (day) EMA. Since EMA 𝑒𝑚 is interpreted as a weighted Moreover, let us explain the difference between time indexes 𝑑 and
𝑛,𝑑
moving average of historical returns 𝑟𝑛,𝑑−1 that places a greater 𝑡. First of all, as shown in our numerical experiment of Section 6,
weight on the recent returns, it captures trended price changes, we implement our PF-based learning method by supposing 𝑡 denotes
a monthly time index, that is, 𝑡 is January, February, …, December.
known as trend indicators.
(𝑚 ,𝑚 ) On the other hand, as the time index 𝑑 to calculate input EMA and
• Moving Average Convergence Divergence (MACD) 𝑒𝑛,𝑑1 2
MACD values, we use daily return data (𝑟𝑛,𝑑 )𝑑 . Such a policy, monthly
(𝑚 ,𝑚2 ) 𝑚 𝑚 portfolio rebalance with daily information input, is often adopted in
𝑒𝑛,𝑑1 ∶= 𝑒𝑛,𝑑1 − 𝑒𝑛,𝑑2 , 𝑚1 < 𝑚2 (10)
several practical points of view including trading costs.
MACD is a momentum indicator, defined as the difference be- With regard to MFs of IT2 FSs, we adopt as follows:
tween short and long term EMA. Let us remark that MACD takes 𝜇𝐴 (𝑥𝑘,𝑖,𝑛,𝑡 )
𝑘,𝑖
a high (resp. low) value when there arises a strong upward (resp.
⎧ { { 3
}}
downward) trend or disappears a downward (resp. upward) trend. 𝑥𝑘,𝑖,𝑛,𝑡 −𝛼𝑘,𝑖,𝑡
⎪min 1, max , 0 , 𝑘 = 1, 3,
⎪ 1 −𝛼 3
𝛼𝑘,𝑖,𝑡 𝑘,𝑖,𝑡
Next, let us describe the following IF-THEN rulebase in our FLS. =⎨ { { 2
}}
⎪min 1, max − 𝑥𝑘,𝑖,𝑛,𝑡 −𝛼𝑘,𝑖,𝑡 , 0 , 𝑘 = 2, 4,
(r-1) IF ⎪ 2 −𝛼 4
𝛼𝑘,𝑖,𝑡
⎩ 𝑘,𝑖,𝑡
20-days EMA is 𝐴1,1 AND 40-days EMA is 𝐴1,2 AND (12)
𝜇𝐴 (𝑥𝑘,𝑖,𝑛,𝑡 )
60-days EMA is 𝐴1,3 AND 120-days EMA is 𝐴1,4 , 𝑘,𝑖

THEN ⎧ { { 4
}}
𝑥𝑘,𝑖,𝑛,𝑡 −𝛼𝑘,𝑖,𝑡
portfolio weight is in [𝑏1 , 𝑏1 ] ⊂ R. ⎪min 1, max ,0 , 𝑘 = 1, 3,
⎪ 2 4
𝛼𝑘,𝑖,𝑡 −𝛼𝑘,𝑖,𝑡
(r-2) IF =⎨ { { 1
}}
⎪min 1, max − 𝑥𝑘,𝑖,𝑛,𝑡 −𝛼𝑘,𝑖,𝑡 , 0 , 𝑘 = 2, 4,
20-days EMA is 𝐴2,1 AND 40-days EMA is 𝐴2,2 AND ⎪ 1 −𝛼 3
𝛼𝑘,𝑖,𝑡
60-days EMA is 𝐴2,3 AND 120-days EMA is 𝐴2,4 , ⎩ 𝑘,𝑖,𝑡

THEN Let us recall that 𝑘 = 1, 3 and 𝑘 = 2, 4 correspond with the high and low.
As for the parameters of the MFs (𝛼𝑖,𝑡 1 , … , 𝛼 4 ), we dynamically adjust
portfolio weight is in [𝑏2 , 𝑏2 ] ⊂ R. 𝑖,𝑡
(r-3) IF as follows:
1
(20,60)-days MACD is 𝐴3,1 AND 𝛼𝑘,𝑖,𝑡 ∶= max {𝑥𝑘,𝑖,𝑛,𝑡 },
𝑛=1,…,𝑁
(20,120)-days MACD is 𝐴3,2 AND 2
𝛼𝑘,𝑖,𝑡 ∶= 0.75 × max {𝑥𝑘,𝑛,𝑖,𝑡 } + 0.25 × min {𝑥𝑘,𝑖,𝑛,𝑡 },
(40,60)-days MACD is 𝐴3,3 AND 𝑛=1,…,𝑁 𝑛=1,…,𝑁
(13)
(40,120)-days MACD is 𝐴3,4 , 3
𝛼𝑘,𝑖,𝑡 ∶= 0.25 × max {𝑥𝑘,𝑛,𝑖,𝑡 } + 0.75 × min {𝑥𝑘,𝑖,𝑛,𝑡 },
𝑛=1,…,𝑁 𝑛=1,…,𝑁
THEN
4
portfolio weight is in [𝑏3 , 𝑏3 ] ⊂ R. 𝛼𝑘,𝑖,𝑡 ∶= min {𝑥𝑘,𝑖,𝑛,𝑡 }.
𝑛=1,…,𝑁

4
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

Actually, those specifications of MFs represent the situation that techni- where all the notations are explained below. Importantly, the equations
cal indicators such as EMA and MACD are relatively evaluated among Eqs. (15), (16) and (17) correspond with Eqs. (1), (2) and (3) for
investment assets for each time 𝑡. Precisely, the MFs in the rules 𝑂𝑡 = 𝑟̄𝑛∗ ,𝑡 , 𝑌𝑡 = (𝜔𝑛,𝑡 )𝑛 and 𝑍𝑡 = (𝑧𝑘,𝑡 )𝑘 , respectively.
(r1) and (r3) (resp. (r2) and (r4)), which are upward-slopping (resp. As described in Appendix, at each time step, the PF algorithm first
downward-slopping) functions, assign the highest/lowest grades to the propagates particles 𝑍𝑡[𝓁] (= (𝑧[𝓁] ) ), 𝓁 = 1, … , 𝐿 based on the state
𝑘,𝑡 𝑘
highest/lowest (resp. lowest/highest) technical indicator values in the equation Eq. (17), and then resample them with weights proportional to
investment assets 𝑛 = 1, … , 𝑁. In other words, our IF-THEN rules their likelihoods 𝑝(𝑂𝑡 |𝑍𝑡[𝓁] ), 𝓁 = 1, … , 𝐿 calculated by the observation
relatively compare indicator values of investment assets to capitalize equation Eq. (15). Then, in the following, let us explain the above state
price change patterns measured by EMA and MACD. space model in reverse order, i.e. Eqs. (17)–(15).
Let us note that according to the procedure in Section 4.1, our IT2
FLS with the IF-THEN rules and the input (𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 generates an 𝑁- • State equation Eq. (17):
dimensional output vector (𝑦𝑛,𝑡 )𝑛 for each time 𝑡. Through imposing First, let us introduce a random variable 𝑣̂ 𝑘,𝑡 following normal
the portfolio weight restriction function 𝜙 ∶ R𝑁 → R𝑁 to the distribution 𝑁(0, 𝜎𝑘2 ), and then define 𝑣𝑘,𝑡 in Eq. (17) as 𝑣𝑘,𝑡 =
(𝑦𝑛,𝑡 )𝑛 for each time 𝑡, we obtain the time-𝑡 portfolio weight 𝜔𝑡 = (𝑣̂ 𝑘,𝑡 , 𝑣̂ 𝑘,𝑡 ). Also, the function 𝜉 ∶ R2 → R2 is specified as 𝜉 = (𝜉, 𝜉),
(𝜔𝑛,𝑡 )𝑛 = 𝜙((𝑦𝑛,𝑡 )𝑛 ), which will be concretely explained in Section 5.2. where 𝜉 ∶ R → R and 𝜉 ∶ R → R. Thus, Eq. (17) can be rewritten
Hereafter, we will represent IT2 FLS itself by the function 𝑓 (⋅; (𝑧𝑘 )𝑘 ) ∶ as follows:
R𝐾×𝐼×𝑁 → R𝑁 ; i.e., (𝑦𝑛,𝑡 )𝑛 = 𝑓 ((𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 ; (𝑧𝑘 )𝑘 ) for each 𝑡, and use ( )
𝐹 (⋅; (𝑧𝑘 )𝑘 ) ∶ R𝐾×𝐼×𝑁 → R𝑁 , introduced in Section 3 as 𝐹 = 𝜙◦𝑓 , 𝑏𝑘,𝑡 = 𝜉 𝑏𝑘,𝑡−1 + 𝑣̂ 𝑘,𝑡
i.e., 𝐹 ((𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 ; (𝑧𝑘 )𝑘 ) = 𝜙(𝑓 ((𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 ; (𝑧𝑘 )𝑘 )). ( ) (18)
𝑏𝑘,𝑡 = 𝜉 𝑏𝑘,𝑡−1 + 𝑣̂ 𝑘,𝑡
5. Investment objective and proposed state space model for IT2 Let us recall that 𝑧𝑘,𝑡 has been defined as 𝑧𝑘,𝑡 = (𝑏𝑘,𝑡 , 𝑏𝑘,𝑡 )𝑘,𝑡 . Also,
FLS learning we note that the definition 𝑣𝑘,𝑡 = (𝑣̂ 𝑘,𝑡 , 𝑣̂ 𝑘,𝑡 ) intends to preserve the
relation 𝑏𝑘,𝑡 > 𝑏𝑘,𝑡 .
5.1. Investment objective
The function 𝜉 = (𝜉, 𝜉) represents the restriction against a range
that each portfolio weight takes. In the empirical study with eight
This section introduces our investment objective represented by
financial assets, the following two cases are tested:
the observation model, Eq. (1). As explained in Section 3, our state-
space approach implements performance evaluation in the observation – Long Only case:
equation. The current paper works on a portfolio construction problem
𝜉(𝑏) = 0.25 × 1{𝑏>0.25} + 𝑏 × 1{0<𝑏<0.25} ,
for the target return replication. Concretely, the replication target 𝑟̄𝑛∗ ,𝑡 (19)
is set to be a stock market index with zero floor returns, which is 𝜉(𝑏) = 0.25 × 1{𝑏>0.25} + 𝑏 × 1{0<𝑏<0.25} .
represented as follows:
{ } – Long-Short case:
𝑟̄𝑛∗ ,𝑡 = 𝛾 max 𝑟𝑛∗ ,𝑡 , 0 , (14)
𝜉(𝑏) = 0.25 × 1{𝑏>0.25} − 0.1 × 1{𝑏<−0.1}
where 𝛾 is a constant adjusted parameter decided by the total position
+ 𝑏 × 1{−0.1<𝑏<0.25} ,
amount admissible in portfolio restriction. For instance, if admissible (20)
∑ 𝜉(𝑏) = 0.25 × 1{𝑏>0.25} − 0.1 × 1{𝑏<−0.1}
total position is 𝑛 |𝜔𝑛,𝑡 | ≤ 1 and investment universe mainly consists
of low return asset class such as bonds, it seems difficult to attain stock + 𝑏 × 1{−0.1<𝑏<0.25} .
returns with zero bound, which means that 𝛾 should be set to be 𝛾 < 1
Here, 1𝐶 for a given set 𝐶 is an indicator function.
for this example. This is the reason why the constant parameter 𝛾 is
In the PF algorithm at time step 𝑡, this state equation Eq. (17)
introduced.
generates 𝑍𝑡[𝓁] = (𝑧[𝓁] ) , 𝓁 = 1, … , 𝐿, which are the candidates of
𝑘,𝑡 𝑘
Since there has been a great demand for investors to construct a
portfolio with restricted downside risk, it is quite meaningful to create the parameters (𝑧𝑘,𝑡 )𝑘 in our fuzzy system.
a product flooring zero bound on a market index which is familiar to • Fuzzy model Eq. (16):
the investors as an investment benchmark. Not that the current paper In a practical implementation of PF, by using the generated
will use popular stock market indexes. candidates of the parameters (𝑧[𝓁] ) , 𝓁 = 1, … , 𝐿, our fuzzy
𝑘,𝑡 𝑘
Let us remark that a long position of a call option is also well- system 𝑓 (⋅; (𝑧[𝓁] ) ) ∶ R𝐾×𝐼×𝑁 → R𝑁 is applied to the inputs
𝑘,𝑡 𝑘
known to realize the similar effect to our replication target 𝑟̄𝑛∗ ,𝑡 . Since
(𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 ∈ R𝐾×𝐼×𝑁 for each particle 𝓁 = 1, … , 𝐿. As a result,
it provides only the upside returns without downside risk, most of the
we obtain a portfolio weight of the securities before applying
investors have strong incentive to hold its position. However, in spite
portfolio restriction 𝜙 ∶ R𝑁 → R𝑁 , i.e., (𝑦[𝓁] 𝑛,𝑡 )𝑛=1,…,𝑁 ∈ R
𝑁
of those desirable payoff characteristics, option trading requires to pay
some cost (premium), which is too expensive in most cases. Therefore, for each 𝓁 = 1, … , 𝐿. Let us introduce the portfolio restriction
∑
our formulation is meaningful, because our approach requires just for a total position, where if the total position 𝑁𝑛=1 |𝜔𝑛,𝑡 | > 1,
∑𝑁
a multi-securities’ investment implementable without paying option the portfolio weights 𝜔𝑛,𝑡 are normalized to be 𝑛=1 |𝜔𝑛,𝑡 | = 1,
premium in advance. preventing from taking leveraged positions.
(𝜔𝑛,𝑡 )𝑛 = 𝜙((𝑦𝑛,𝑡 )𝑛 )
5.2. Proposed state space model for IT2 FLS learning
(𝑦𝑛,𝑡 )𝑛 (21)
= 1{∑𝑛 |𝑦𝑛,𝑡 |≤1} (𝑦𝑛,𝑡 )𝑛 + 1{∑𝑛 |𝑦𝑛,𝑡 |>1} ∑
Now, as a learning framework of the proposed IT2 FLS, this section |𝑦
𝑛 𝑛,𝑡 |
introduces the following state-space representation. ∑
Let us also note that if the total position 𝑁 𝑛=1 |𝜔𝑛,𝑡 | < 1, the
∑
𝑁 ∑𝑁
remaining portion 1 − 𝑛=1 |𝜔𝑛,𝑡 | is invested in cash with zero
𝑟̄𝑛∗ ,𝑡 = 𝜔𝑛,𝑡 𝑟𝑛,𝑡 + 𝑢𝑡 , (15)
interest rate.
𝑛=1
• Observation equation Eq. (15):
(𝜔𝑛,𝑡 )𝑛 = 𝜙◦𝑓 ((𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 ; (𝑧𝑘,𝑡 )𝑘 ), (16)
First, observation noises 𝑢𝑡 is supposed to follow normal distribu-
𝑧𝑘,𝑡 = 𝜉(𝑧𝑘,𝑡−1 + 𝑣𝑘,𝑡 ), 𝑘 = 1, … , 𝐾, (17) tion, i.e., 𝑢𝑡 ∼ 𝑁(0, 𝜎𝑢2 ).

5
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

Algorithm 1 Pseudo code for our proposed methodology

[1] [𝐿]
1: Generate the initial state vector {𝑍0 , ⋯ , 𝑍0 },
where 𝑍0[𝓁] represents the parameters for the fuzzy system
𝑓 (⋅; (𝑧𝑘,𝑡 )𝑘 ), i.e. 𝑍0[𝓁] = (𝑧[𝓁] ) .
𝑘,0 𝑘
2: for 𝑡 = 1 to 𝑇 at each time do
3: Observe new data 𝑟𝑡 = (𝑟𝑛,𝑡 )𝑛 reflecting the current environmental
change.
4: Calculate technical indicators 𝑋𝑡 = (𝑥𝑘,𝑖,𝑛,𝑡 )𝑘,𝑖,𝑛 for the inputs of
fuzzy system from (𝑟𝑠 )𝑡𝑠=1 .
5: Calculate the replication target 𝑂𝑡 = 𝑟̄𝑡,𝑛∗ = max{𝑟𝑛∗ ,𝑡 , 0}.
6: for 𝓁 = 1 to 𝐿 on each particle do
7: Generate system noise 𝑣[𝓁] 𝑡 .
8: Compute 𝑍𝑡[𝓁] from the system noise 𝑣[𝓁] ̂ [𝓁]
𝑡 and 𝑍𝑡−1 through the
system equation Eq. (17).
9: Simulate the portfolio weight 𝑌𝑡[𝓁] = (𝜔[𝓁]
𝑛,𝑡 )𝑛
by our FLS Eq. (16), i.e. 𝑌𝑡[𝓁] = 𝜙◦𝑓 (𝑋𝑡 ; 𝑍𝑡[𝓁] ) using KM
algorithm.
10: Evaluate the importance weight of the parameter vector 𝑍𝑡[𝓁]
Fig. 1. Cumulative returns of stock index futures. as 𝛿𝑡[𝓁] ≡ 𝑝(𝑂𝑡 |𝑍𝑡[𝓁] )
by using the likelihood function 𝑝 calculated based on 𝑌𝑡[𝓁] and
the resulting observation equation Eq. (15).
The current work has utilized the replication target returns 𝑟̄𝑛∗ ,𝑡 11: end for
[𝓁] ∑
as the investment objective in Section 5.1. Let us note that a 12: Normalize the importance weights 𝛿̃𝑡 = 𝛿𝑡[𝓁] ∕ 𝐿 𝑙=1 𝛿𝑡
[𝓁]
for the
∑ next resampling procedure.
portfolio rate of return at time 𝑡 is represented as 𝑁𝑛=1 𝜔𝑛,𝑡 𝑟𝑛,𝑡 , 13: Resample {𝑍̂ 𝑡[1] , ⋯ , 𝑍̂ 𝑡[𝐿] } from {𝑍𝑡[1] , ⋯ , 𝑍𝑡[𝐿] }
which is derived as follows: [1] [𝐿]
in proportion to the normalized weights {𝛿̃𝑡 , ⋯ , 𝛿̃𝑡 }.
∑
∑
𝑁+1 ∑
𝑁+1 14: Calculate the average of the parameter vectors 𝑍𝑡 = 𝐿 𝑍̂ [𝓁] ∕𝐿
̃
𝓁=1 𝑡
𝜔𝑛,𝑡 (1 + 𝑟𝑛,𝑡 ) = 1 + 𝜔𝑛,𝑡 𝑟𝑛,𝑡 as a representative value.
𝑛=1 𝑛=1 15: Decide the actual portfolio weights (𝜔̃ 𝑛,𝑡+1 )𝑛 during the period
(22)
∑
𝑁
[𝑡, 𝑡 + 1)
=1+ 𝜔𝑛,𝑡 𝑟𝑛,𝑡 ,
by (𝜔̃ 𝑛,𝑡+1 )𝑛 = 𝜙◦𝑓 (𝑋𝑡 ; 𝑍̃ 𝑡 )
𝑛=1
16: end for
where 𝑛 = 𝑁 + 1 denotes cash or bank account with a (lending)
interest rate 𝑟𝑁+1,𝑡 ≡ 0 and a portfolio weight 𝜔𝑁+1,𝑡 ≡ 1 − 6. Empirical experiment
∑𝑁
𝑛=1 𝜔𝑛,𝑡 for all 𝑡.
That is, in the right-hand-side of the observation equation Eq. This section presents our empirical experiment to confirm the valid-
(15), after an investor constructs his/her portfolio according to ity of our approach. That is, after the detailed setup for the experiment
is explained in Section 6.1, Section 6.2 presents the out-of-sample
the weight (𝜔𝑛,𝑡 )𝑛=1,…,𝑁 calculated from the IT2 FLS at time 𝑡 − 1,
∑ investment simulation results.
its investment return realizes at time 𝑡 as 𝑁𝑛=1 𝜔𝑛,𝑡 𝑟𝑛,𝑡 . Remember
that 𝑟𝑛,𝑡 denotes a rate of return of 𝑛th security realized at time 𝑡. 6.1. Setup
Moreover, 𝑟̄𝑛∗ ,𝑡 in the left-hand-side stands for a replication target
return at time 𝑡. 6.1.1. Data
In other words, the resampling step in the PF algorithm selects As listed in Table 1, we use time-series return data, downloaded by
Bloomberg, for stock market price indexes futures and 10-year bond
from the propagated particles (𝜔[𝓁] [𝓁]
𝑛,𝑡 )𝑛 , or (𝑧𝑘,𝑡 )𝑘 , 𝓁 = 1, … , 𝐿
futures for US, Japan, Germany and UK, where cumulative returns of
which realize the replication target return 𝑟̄𝑛∗ ,𝑡 . Thus, the obtained stocks and bonds are displayed in Figs. 1 and 2, respectively. Also,
′ ′]
filtered states 𝑍̂ 𝑡[𝓁 ] = (𝑧̂ [𝓁
𝑘,𝑡 𝑘
) (𝓁 ′ = 1, … , 𝐿) are utilized in the the total data period is from 1990/12/3 to 2019/8/30. Hereafter, we
time-𝑡 implementation of the fuzzy system, which decides the employ Bloomberg ticker codes shown in Table 1. Let us notice that all
of the assets are futures, which implies those returns are excess returns.
portfolio weights (𝜔𝑛,𝑡+1 )𝑛 . Precisely, we use the mean vector of
′ ′] Namely, it is not necessary to subtract funding costs or risk-free rates in
𝑍̂ 𝑡[𝓁 ] = (𝑧̂ [𝓁
𝑘,𝑡 𝑘
) over 𝓁 ′ = 1, … , 𝐿 as the estimates of (𝑧𝑘 )𝑘 at time
our performance evaluation such as Sharpe ratio. Also, our price data
𝑡. Let us notice that we do not exploit the future information in are generated by rolling futures based on a default setting of Bloomberg
the above procedure, that is, we only use the return data until functions in a generic rollover, where cumulative returns of stocks and
time 𝑡 to determine (𝑧𝑘,𝑡 )𝑘 and (𝜔𝑛,𝑡+1 )𝑛=1,…,𝑁 . bonds are displayed in Figs. 1 and 2.
Now, repeating this procedure sequentially updates the filtered
′ [𝓁 ′ ] 6.1.2. Some details for investment
states 𝑍̂ 𝑡[𝓁 ] = (𝑧̂ 𝑘,𝑡 ) (𝓁 ′ = 1, … , 𝐿) through time by reflecting the
As shown in Section 6.1.1, we use daily return data to calculate
past measurement (performance), which gives our fuzzy model input variables (𝑥𝑘,𝑖,𝑛,𝑡 ). However, it is well-known that daily portfolio
high adaptability against the change of environment. rebalance requires excess trading costs. Then, the current work imple-
ments portfolio rebalance at each end of month. Here, since our trading
instruments are futures on global stock market indexes and sovereign
Finally, we present the pseudo-code of our proposed methodology bonds, we set trading costs as 2.5 bps for each unit amount of money
to help the further understanding of our algorithm. trading.

6
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

Table 1 𝑡. Hence, the total transaction cost at time 𝑡 equals to the summation
Data.
of 𝑑𝑛 |𝜔𝑛,𝑡+1 𝑉𝑡 − 𝜔𝑛,𝑡−1 𝑉𝑡−1 (1 + 𝑟𝑛,𝑡 )| for all 𝑛. In this paper, we set 𝑑𝑛 =
Underlying asset/index Ticker 2.5 bps (𝑛 = 1, … , 𝑁), which is a reasonable assumption for transaction
S&P500 (US stock market index) SP fee in futures market with high liquidity.
TOPIX (Japanese stock market index) TP
Next, we also introduce investment ratios to evaluate the perfor-
DAX (German stock market index) GX
FTSE100 (UK stock market index) Z mances of our proposals, which are typically used in finance. For a
10y US Government bond TY given time-series of monthly investment returns (𝑅𝑡 )𝑡=1,…,𝑇 and port-
10y Japanese Government bond JB folio values (𝑉𝑡 )𝑡=0⋯𝑇 , the performance ratios are defined as follows:
10y Germany Government bond RX
10y UK Government bond G • Compound return (CR):
{ 𝑇 }12∕𝑇
∏
𝐶𝑅 ≡ (1 + 𝑅𝑡 ) − 1. (26)
𝑡=1

CR is one of the most fundamental performance measures, which

corresponds with a geometric annualized average of investment
returns.
• Standard deviation (SD):
{ }1∕2
12 ∑ 1 ∑
𝑇 𝑇
𝑆𝐷 ≡ ̄ 2
(𝑅𝑡 − 𝑅) , 𝑅̄ ≡ 𝑅. (27)
𝑇 𝑡=1 𝑇 𝑡=1 𝑡

SD is one of the most basic variables both in theory and practice

for portfolio risk management, known as volatility.
• Downside deviation (DD):
{ }1∕2
12 ∑
𝑇
𝐷𝐷 ≡ min(0, 𝑅𝑡 )2 . (28)
𝑇 𝑡=1

Differently from SD, DD regards only negative return as risk,

which seems reasonable for investment performance evaluation.
Fig. 2. Cumulative returns of bond futures.
• Maximum drawdown (MDD):
𝑀𝑡 − 𝑉 𝑡
𝑀𝐷𝐷 ≡ max , 𝑀𝑡 ≡ max 𝑉𝑠 . (29)
1≤𝑡≤𝑇 𝑀𝑡 0≤𝑠≤𝑡
Also, we test the four cases of replication targets 𝑟̄𝑛∗ ,𝑡 as 𝑛∗ =
1, 2, 3, 4: MDD is a max value in drawdowns realized in a given investment
horizon [0, 𝑇 ], where a drawdown is defined as a decline from
𝑟̄𝑛∗ ,𝑡 = 𝛾 max{𝑟1,𝑡 , 0},
the past peak value 𝑀𝑡 to the present value 𝑉𝑡 at each time 𝑡.
𝑟̄𝑛∗ ,𝑡 = 𝛾 max{𝑟2,𝑡 , 0}, Shortly, MDD tells us the worst scenario for a given investment
(23)
𝑟̄𝑛∗ ,𝑡 = 𝛾 max{𝑟3,𝑡 , 0}, horizon, which means how much loss an investor suffers from
if he/she enter and exit an investment at the worst timing. As
𝑟̄𝑛∗ ,𝑡 = 𝛾 max{𝑟4,𝑡 , 0},
it is widely recognized in practice that investment performance
where 𝑟1,𝑡 and 𝑟2,𝑡 correspond with the rates of returns of SP, TP, DX and largely depends on its starting and exiting timing, MDD is thought
Z, i.e. the futures on stock market indexes of US, Japan, Germany, and to be an important measure. Namely, small MDD implies that an
UK (S&P500, TOPIX, DAX, FTSE100). Based on this replication target investor has not suffered from a large loss, whenever he/she starts
and investment universe described in the previous Section 6.1.1, we the investment, at least on the past data.
judge a proper parameter value of 𝛾 is 0.5. Let us note that since those • Sharpe ratio (ShR):
stock market indexes realize one of the most typical investment returns
in global financial markets, the demand for those zero-floor returns is ̄
𝑆ℎ𝑅 ≡ 𝑅∕𝑆𝐷. (30)
extremely high among domestic institutional investors. In asset management theory and practice, risk-adjusted returns
Now, we will introduce the definition of the portfolio values are well-known to represent a ‘‘true’’ investment performance.
{𝑉𝑡 }𝑡=0,…,𝑇 and investment returns {𝑅𝑡 }𝑡=1,…,𝑇 as follows. Among them, ShR is the most famous one, which is also a basic
( )
∑𝑁 quantity in the field of financial economics. Let us remark that
𝑉𝑡+1 = 𝑉𝑡 1 + 𝜔𝑛,𝑡+1 𝑟𝑛,𝑡+1 since we have already taken into account funding costs in raw
𝑛=1 return data as stated in Section 6.1.1, we do not subtract a
∑
𝑁
risk-free rate from 𝑅̄ in the ShR definition.
− 𝑑𝑛 |𝜔𝑛,𝑡+1 𝑉𝑡 − 𝜔𝑛,𝑡 𝑉𝑡−1 (1 + 𝑟𝑛,𝑡 )|, (24)
• Sortino ratio (SoR):
𝑛=1

𝑅𝑡+1 = 𝑉𝑡+1 ∕𝑉𝑡 − 1, (25) ̄

𝑆𝑜𝑅 ≡ 𝑅∕𝐷𝐷. (31)

where 𝑑𝑛 denotes a transaction spread of 𝑛th security, respectively, and
the initial portfolio value is normalized to one, i.e. 𝑉0 = 1
∑
The penalty term 𝑁 𝑛=1 𝑑𝑛 |𝜔𝑛,𝑡+1 𝑉𝑡 − 𝜔𝑛,𝑡 𝑉𝑡−1 (1 + 𝑟𝑛,𝑡 )| in Eq. (24) is
the total transaction cost arising from the allocation change at time 𝑡.
Since 𝜔𝑛,𝑡 and 𝜔𝑛,𝑡+1 are portfolio weights of the 𝑛th security during
[𝑡 − 1, 𝑡) and [𝑡, 𝑡 + 1), 𝜔𝑛,𝑡 𝑉𝑡−1 (1 + 𝑟𝑛,𝑡 ) and 𝜔𝑛,𝑡+1 𝑉𝑡 indicate the values
of the 𝑛th security before and after the position change at time 𝑡, re-
spectively. That is, |𝜔𝑛,𝑡+1 𝑉𝑡 − 𝜔𝑛,𝑡 𝑉𝑡−1 (1 + 𝑟𝑛,𝑡 )| represents the necessary
amount of money for the position change of the 𝑗th security at time
SoR is also useful because it adjusts risk by using DD, which
makes it possible to focus on only downside risk.
6.1.3. Some details for particle filter
To implement our PF method, we decide several parameters. First,
let us notice that the standard calculation in IT2 FLS requires a heavier
computational cost than that of type-1 FLS. Taking it into account, we
decide to execute our PF by setting the number of particles 𝐿 = 1000
at 100 times, which mitigates computational time, compared to simple

7
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

Table 2 Table 4
Performance ratios: SP500 (US stock market index). Performance ratios: DAX (German stock market index).
SP500 type2-LO type1-LO type2-LS type1-LS DAX type2-LO type1-LO type2-LS type1-LS
Compound return 3.4% 3.7% 3.8% 3.4% 3.0% Compound return 3.2% 3.8% 3.9% 3.5% 3.4%
Standard deviation 7.2% 3.0% 3.5% 2.8% 3.5% Standard deviation 10.3% 3.1% 3.5% 3.1% 3.5%
Downside deviation 5.1% 1.5% 1.9% 1.3% 2.9% Downside deviation 7.3% 1.6% 2.0% 1.6% 2.1%
Maximum drawdown 32.8% 5.5% 7.0% 4.5% 10.4% Maximum drawdown 47.0% 7.5% 9.4% 7.0% 10.0%
Sharpe ratio 0.47 1.24 1.08 1.22 0.86 Sharpe ratio 0.31 1.22 1.11 1.12 0.95
Sortino ratio 0.67 2.44 1.97 2.53 1.52 Sortino ratio 0.44 2.33 1.98 2.14 1.61

Table 3 Table 5
Performance ratios: TOPIX (Japanese stock market index). Performance ratios: FTSE100 (UK stock market index).
TOPIX type2-LO type1-LO type2-LS type1-LS FTSE100 type2-LO type1-LO type2-LS type1-LS
Compound return 1.1% 3.3% 3.4% 2.6% 2.6% Compound return 2.2% 3.5% 3.7% 3.1% 3.4%
Standard deviation 9.3% 2.9% 3.5% 2.9% 3.7% Standard deviation 7.1% 3.0% 3.4% 2.8% 3.4%
Downside deviation 6.1% 1.6% 2.1% 1.7% 2.4% Downside deviation 5.0% 1.6% 2.0% 1.5% 2.0%
Maximum drawdown 34.0% 5.7% 8.9% 5.6% 7.9% Maximum drawdown 29.6% 7.2% 8.5% 7.0% 8.8%
Sharpe ratio 0.12 1.15 0.98 0.90 0.70 Sharpe ratio 0.31 1.16 1.08 1.10 1.00
Sortino ratio 0.18 2.10 1.65 1.54 1.08 Sortino ratio 0.44 2.14 1.84 2.13 1.68

execution with 𝐿 = 100,000. We take an average of those one-hundred
executions of PF to produce final investment results.
With regard to standard deviation parameters of state and obser-
vation noises following normal distributions, i.e., 𝜎𝑢 and 𝜎𝑘 , we set as
follows:
𝜎𝑢 = 0.005, 𝜎𝑘 = 0.05. (32)
Let us also note that although PF algorithm is applied for all the
data from 1990/12/3 to 2019/8/30, investment simulation starts from
1992/12/3, because PF estimation, as well as EMA values, depends on
the setting of initial values for the first several periods. In other words,
we use the first two years’ data as training periods.
6.2. Investment result
Tables 2–5 show the performance ratios defined in Section 6.1.2.
In Tables 2–5, the columns ‘‘SP500’’, ‘‘TOPIX’’, ‘‘DAX’’, and ‘‘FTSE100’’
represent the performances for the buy-and-hold strategies of SP500,
TOPIX, DAX, and FTSE100, respectively. Let us notice that since the
target returns 𝑟̄𝑛∗ ,𝑡 are defined by Eq. (23), we display the ratios of
investment returns (𝛾 × 𝑟1,𝑡 )𝑡 (𝛾 = 0.5) as those buy-and-hold strate-
gies. Also, we note that the characters ‘‘LO’’ and ‘‘LS’’ in the column
labels (‘‘type2-LO’’, ‘‘type1-LO’’, ‘‘type2-LS’’,‘‘type2-LS’’) of Tables 2–5
indicate the case of Long Only (LO) and Long-Short (LS) in Eqs. (19)
and (20).
Besides, we have introduced a type-1 Takagi-Sugeno FLS, for perfor-
mance comparison to validate the effectiveness of our proposal, which
differs in the following two points from the proposed type-2 model:
• IT2 FSs (𝐴𝑘,𝑖 ) are replaced to type-1 FSs (𝐴′𝑘,𝑖 ), that is, those MFs
𝜇𝐴′ are defined as follows:
𝑘,𝑖
Japan, Germany and UK, i.e. SP500, TOPIX, DAX, and FTSE100. In
other words, our proposals tend to attain higher investment returns
(compound returns) than buy-and-hold strategies of stock market index
futures with significant risk reduction such as standard deviation and
maximum drawdown. In particular, the standard deviations of all the
FLSs (type1-LO, type1-LS, type2-LO, type2-LS) are less than half of
those of buy-and-hold strategies for all the cases of SP500, TOPIX, DAX,
and FTSE100. Also, the maximum drawdowns of the FLSs are less than
a third of those of buy-and-hold strategies.
In addition, it is an important result that the type-2 fuzzy mod-
els (type2-LO and type2-LS) accomplish better risk-adjusted returns
(Sharpe and Sortino ratios) and maximum drawdowns than type-1
models (type1-LO and type1-LS), respectively, for all the stock market
indexes. Especially, IT2 FLSs improve type-1 FLSs in risk performance
measures such as downside deviation and maximum drawdown, which
is important in terms of our investment objective, i.e. the zero-floored
returns.
To check the robustness of those results, we will implement a
statistical comparison on Sharpe ratios between IT2 FLSs and type-1
FLSs. In particular, by regarding Sharpe ratio that is one of the most
well-known and important performance measure as a random variable,
it makes us possible to statistically check the advantage of our proposed
IT2 FLS against the benchmark type-1 FLS.
Concretely, Opdyke (2007) showed a sample-based estimate 𝑆ℎ𝑅 ̂ of
a true Sharpe ratio 𝑆ℎ𝑅, asymptotically follows a normal distribution
under stationary and ergodicity assumptions for time-series of portfolio
returns {𝑅𝑡 }𝑡=1,…,𝑇 :
√ ( ) 𝑎 ( ( ) )
𝑆ℎ𝑅2 𝜇4 𝜇
̂ − 𝑆ℎ𝑅 ∼
𝑇 𝑆ℎ𝑅 𝑁 0, 1 + − 1 − 𝑆ℎ𝑅 3 , 𝑇 → ∞
4 4 3
𝜎 𝜎
(34)

𝜇𝐴′ (𝑥𝑘,𝑖,𝑛,𝑡 ) where

𝑘,𝑖

⎧ { { 4
}} • 𝑆ℎ𝑅 = 𝜇∕𝜎.
𝑥𝑘,𝑖,𝑛,𝑡 −𝛼𝑘,𝑖,𝑡
⎪min 1, max ,0 , 𝑘 = 1, 3, • 𝜇 = 𝐸[𝑅𝑡 ], 𝜎 2 = 𝐸[(𝑅𝑡 − 𝜇)2 ]
⎪ 1 4
𝛼𝑘,𝑖,𝑡 −𝛼𝑘,𝑖,𝑡 (33)
=⎨ { { 1
}} • 𝜇𝑖 = 𝐸[(𝑅𝑡 − 𝜇)𝑖 ], 𝑖 = 3, 4.
⎪min 1, max − 𝑥𝑘,𝑖,𝑛,𝑡 −𝛼𝑘,𝑖,𝑡 , 0 , 𝑘 = 2, 4,
⎪ 1 −𝛼 4
𝛼𝑘,𝑖,𝑡 Let us note that 𝜇𝑖 denotes the 𝑖th moment of a random variable 𝑅𝑡 ,
⎩ 𝑘,𝑖,𝑡
which means that 𝜇3 ∕𝜎 3 and 𝜇4 ∕𝜎 4 stand for skewness and kurtosis of
where the parameters of the MFs (𝛼𝑖,𝑡 1 and 𝛼 4 ) are defined in {𝑅𝑡 }𝑡=1,…,𝑇 , respectively.
𝑖,𝑡
Eq. (13). Particularly in the current study, we use the following asymptotic
• The interval [𝑏𝑘 , 𝑏𝑘 ] is replaced to a point 𝑏𝑘 ∈ R. Naturally, distribution of the difference between two Sharpe ratios 𝑆ℎ𝑅𝑎 and
the parameters (𝑏𝑘 )𝑘 are sequentially learned by our proposed PF 𝑆ℎ𝑅𝑏 of two funds with investment returns {𝑅𝑎𝑡 } and {𝑅𝑏𝑡 } to compare
method as time-varying state variables 𝑍𝑡 = (𝑏𝑘,𝑡 )𝑘 . our proposed IT2 FLS with the benchmark type-1 FLS. According to
Opdyke (2007), the asymptotic distribution of 𝑆ℎ𝑅 ̂ 𝑑𝑖𝑓 𝑓 ∶= (𝑆ℎ𝑅
̂𝑎 −
Based on Tables 2–5, it is observed that risk-adjusted returns, ̂ 𝑏 ) − (𝑆ℎ𝑅𝑎 − 𝑆ℎ𝑅𝑏 ) is as follows:
𝑆ℎ𝑅
i.e., Sharpe and Sortino ratios of our proposals successfully outper- √ 𝑎
form the buy-and-hold strategies of stock market index futures of US, ̂ 𝑑𝑖𝑓 𝑓 ∼
𝑇 𝑆ℎ𝑅 𝑁(0, 𝑉 𝑎𝑟𝑑𝑖𝑓 𝑓 ), 𝑇 → ∞ (35)

8
A. Takahashi and S. Takahashi Engineering Applications of Artificial Intelligence 100 (2021) 104154

Table 6 Table 7
Probability of {ShR of Type2 > ShR of Type1}. Performance ratios of type-2 FLS on SP500: Static vs. dynamic.
SP500 TOPIX DAX FTSE100 Dynamic Static
LongOnly 95.1% 91.9% 83.4% 75.2% Compound return 3.42% 3.91%
LongShort 84.9% 86.8% 87.6% 74.4% Standard deviation 2.80% 3.42%
Maximum drawdown 4.51% 7.51%
Sharpe ratio 1.22 1.14
Sortino ratio 2.53 2.03
where
( ) ( )
𝑆ℎ𝑅2𝑎 𝜇4𝑎 𝜇3𝑎 𝑆ℎ𝑅2𝑏 𝜇4𝑏
𝑉 𝑎𝑟𝑑𝑖𝑓 𝑓 = 1 + −1 − 𝑆ℎ𝑅𝑎 +1+ −1 simple example: That is, for comparison, we have implemented invest-
4 𝜎𝑎4 𝜎𝑎3 4 𝜎𝑏4
𝜇3𝑏 ment simulation for the IT2 FLS with in-sample static parameters by
− 𝑆ℎ𝑅𝑏 using information of a whole period 𝑡 = 1, … , 𝑇 . Precisely, as the static
𝜎𝑏3
{[ ( )] parameters we employ the mean vector of the filtered state variables at
′ ′]
𝑆ℎ𝑅𝑎 𝑆ℎ𝑅𝑏 𝜇2𝑎,2𝑏 1 𝜇2𝑎,1𝑏 time-𝑇 in the PF algorithm, i.e. 𝑍̂ 𝑇[𝓁 ] = (𝑧̂ [𝓁
𝑘,𝑇 𝑘
) defined in Section 5.2.
−2 𝜌𝑎,𝑏 + −1 − 𝑆ℎ𝑅𝑎
4 𝜎𝑎2 𝜎𝑏2 2 𝜎𝑏 𝜎𝑎2 According to Table 7, risk-adjusted returns (Sharpe/Sortino ratios),
} as well as maximum drawdown, of the proposed dynamic models
1 𝜇1𝑎,2𝑏
− 𝑆ℎ𝑅𝑏 , outperform the static model. Moreover, the probability that the Sharpe
2 𝜎𝑎 𝜎 2 𝑏 ratio obtained by our dynamic parameter model is higher than the
(36) one by the static model is about 70%. Thereby, our proposed dynamic
parameter models attain higher performances than the in-sample static
and parameter models, which supports the advantage of our proposal.

• 𝜇𝑖𝑎 = 𝐸[(𝑅𝑎𝑡 − 𝜇𝑎 )𝑖 ], 𝜇𝑖𝑏 = 𝐸[(𝑅𝑏𝑡 − 𝜇𝑏 )𝑖 ], 𝑖 = 3, 4,

• 𝜎𝑎2 = 𝐸[(𝑅𝑎𝑡 − 𝜇1𝑎 )2 ], 𝜎𝑏2 = 𝐸[(𝑅𝑏𝑡 − 𝜇1𝑏 )2 ],
• 𝜇𝑖𝑎,𝑗𝑏 = 𝐸[(𝑅𝑎 − 𝜇1𝑎 )𝑖 (𝑅𝑏 − 𝜇1𝑏 )𝑗 ], 𝑖, 𝑗 = 1, 2.
Based on those results, Table 6 shows probabilities that Sharpe
ratios of our IT2 FLS are higher than those of the type-1 FLSs, i.e. Prob
(ShR of Type2 > ShR of Type1), which mark high levels from 74.4% to
95.1%.
6.3. Discussion on the effectiveness of our approach with type-2 FLS
As shown in Section 6.2, our investment simulation results have
illustrated the superiority of our type-2 FLSs against the type-1 models.
Since both of the type-1 and type-2 FLSs are learned by our state-
space approach, those results imply that type-2 modeling itself has
contributed additional improvement of the performances.
For example, Karnik and Mendel (1999) pointed out that higher
degrees of freedom of type-2 models make it possible to create those
better performance compared with type-1 models. In addition, Hagras
(2004) has categorized sources of uncertainty that FLCs face into the
following three types:
(i) Uncertainties in inputs to the FLC: They are translated to un-
certainties in the antecedents MFs, because measurements are
typically noisy and are affected by the conditions of observation.
(ii) Uncertainties in control actions: They are translated to uncertain-
ties in the output MFs of the FLC.
(iii) Uncertainties in linguistic expression: The meaning of words used
in the antecedent and consequent parts can be uncertain as words
mean different things to different people.
Hagras (2004) has indicated that all of these uncertainties are trans-
lated into uncertainties of MFs, so that type-2 FSs can explicitly take
those uncertainties into account in a FLS. In our empirical results,
it can be said that a type-2 FLS is able to improve the investment
performances by modeling uncertainties (i) and (iii).
Our state-space learning approach focuses on the uncertainty (ii) by
adapting to time-varying nature of financial markets. In particular, IT2
FLS cannot fully deal with the uncertainty (ii), because there are not
FSs in the consequent parts. Further, the degree of freedoms of IT2 FLSs
are not always enough, because for instance the investment decision
changes from buying to selling (from selling to buying), depending
on the current market conditions. On the contrary, our state-space
approach with time-varying parameters is effective for investment de-
cisions under those conditions. Let us demonstrate this point by using a
7. Conclusion
The current work has presented a new interval type-2 fuzzy logic
system (IT2 FLS) with time-varying parameters under a general state-
space framework. In particular, the state-space framework has realized
the adaptive learning of IT2 FLSs through regarding those parameters
as unobservable state variables, which are sequentially estimated based
on Bayesian filtering algorithms.
The main contribution of this paper is that our on-line learning
method is implemented to show the advantage of IT2 FLSs to type-1
FLSs in the empirical study of financial investment with global financial
assets during about three decades, which has still been unexplored in
empirical study of this area. Concretely, the proposed IT2 FLS outper-
formed the type-1 FLS for various investment performance measures
including average returns, Sharpe/Sortino ratios and maximum draw-
downs. Moreover, we have confirmed the robustness of the advantage
of IT2 FLSs by a statistical comparison on Sharpe ratios, one of the most
important performance measures.
Although the current work exogenously decided the parameters of
membership functions in IT2 FLS, it is possible to incorporate them into
state variables, which is one of the most important future researches.
Moreover, we will consider extending IT2 FLSs to more general type-2
FLSs with reduction of computational burden.
CRediT authorship contribution statement
Akihiko Takahashi: Conceptualization, Methodology, Formal anal-
ysis, Investigation, Writing - review & editing, Supervision, Project
administration. Soichiro Takahashi: Conceptualization, Methodology,
Software, Formal analysis, Investigation, Writing - original draft, Writ-
ing - review & editing, Visualization.
Declaration of competing interest
The authors declare that they have no known competing finan-
cial interests or personal relationships that could have appeared to
influence the work reported in this paper.
Acknowledgments
The authors are grateful to Mr. Takahiko Suenaga, Mr. Takeshi
Hakamada and Mr. Masayuki Takahashi at GCI Asset Management Inc.
for valuable helps. This research is supported by CARF (Center for
Advanced Research in Finance), Japan.

9
A. Takahashi and S. Takahashi
Appendix. State space model and particle filter
A state space model assumes that there exist unobservable latent
variables called state variables behind observed time-series data, which
are driven by stochastic processes. Precisely, it consists of the following
observation and state equations.
𝑂𝑡 = 𝐻(𝑍𝑡 , 𝑢𝑡 ), [observation equation] (37)
𝑍𝑡 = 𝐺(𝑍𝑡−1 , 𝑣𝑡 ), [state equation] (38)
where 𝑂𝑡 and 𝑍𝑡 are a vector of observable and state variables, respec-
tively. Besides, 𝑢𝑡 and 𝑣𝑡 denote random variables for observation and
state transition, respectively. Also, the functions 𝐻 and 𝐺 represent
non-linear functions in general.
Bayesian filtering technique is an on-line statistical algorithm to
sequentially estimate the state variables 𝑍𝑡 through the observed data
until time 𝑡, i.e. 𝑂1∶𝑡 ≡ (𝑂1 , … , 𝑂𝑡 ). Importantly, filtering approaches
are appropriate for reflecting dynamic changes of environments, be-
cause their estimations are updated for each time of new observation
data arrival. In particular, particle filtering (PF) resorts to Monte Carlo
simulation for the estimation of state variables. The advantage of PF is
that it is applicable to non-linear and non-Gaussian settings, differently
from linear filtering methods such as Kalman filter.
Hereafter, we introduce our PF algorithm, developed by Gordon
et al. (1993) and Kitagawa (1996). First of all, Bayes formula shows
𝑝(𝑍𝑡 |𝑂1∶𝑡 ) ∝ 𝑝(𝑂𝑡 |𝑍𝑡 )𝑝(𝑍𝑡 |𝑂1∶𝑡−1 ). (39)
Then, a sampling importance resampling (SIR) method enables us
to obtain the samples {𝑍̂ 𝑡[𝓁] }𝓁=1,…,𝐿 from the posterior 𝑝(𝑍𝑡 |𝑂1∶𝑡 ) by
regarding the prior 𝑝(𝑍𝑡 |𝑂1∶𝑡−1 ) as an importance function. That is,
after sampling {𝑍𝑡[𝓁] }𝓁=1,…,𝐿 from the distribution 𝑝(𝑍𝑡 |𝑂1∶𝑡−1 ), those
samples are re-sampled with weights proportional to the likelihood
𝑝(𝑂𝑡 |𝑍𝑡 ), which gives us {𝑍̂ 𝑡[𝓁] }𝓁=1,…,𝐿 . Let us remark that those random
samples are called ‘‘particles’’.
To get the samples {𝑍𝑡[𝓁] }𝓁=1,…,𝐿 from the prior 𝑝(𝑍𝑡 |𝑂1∶𝑡−1 ), the
following method is employed. First, let us note that
𝑝(𝑍𝑡 |𝑂1∶𝑡−1 ) = 𝑝(𝑍𝑡 , 𝑍𝑡−1 , 𝑣𝑡 |𝑂1∶𝑡−1 )𝑑𝑍𝑡−1 𝑑𝑣𝑡
∬ Kasabov, N.K., Song, Q., 2002. DENFIS: dynamic evolving neural-fuzzy inference system
= 𝑝(𝑍𝑡 |𝑍𝑡−1 , 𝑣𝑡 )𝑝(𝑣𝑡 )𝑝(𝑍𝑡−1 |𝑂1∶𝑡−1 )𝑑𝑍𝑡−1 𝑑𝑣𝑡 (40)
∬
= 𝛿(𝑍𝑡 − 𝐺(𝑍𝑡−1 , 𝑣𝑡 ))𝑝(𝑣𝑡 )𝑝(𝑍𝑡−1 |𝑂1∶𝑡−1 )𝑑𝑍𝑡−1 𝑑𝑣𝑡 ,
∬ evaluation. IEEE Trans. Ind. Electron. 59 (11), 4443–4455.
where 𝛿(⋅) is the Dirac delta function. Then, we obtain the sam-
ples {𝑍𝑡[𝓁] }𝓁=1,…,𝐿 from 𝑝(𝑍𝑡 |𝑂1∶𝑡−1 ) by setting 𝑍𝑡[𝓁] = 𝐺(𝑍̂ 𝑡−1
[𝓁] [𝓁]
, 𝑣𝑡 ),
[𝓁] [𝓁]
for given samples of {𝑣 }𝓁=1,…,𝐿 and {𝑍̂ }𝓁=1,…,𝐿 from 𝑝(𝑣𝑡 ) and
𝑡 𝑡−1
𝑝(𝑍𝑡−1 |𝑂1∶𝑡−1 ), respectively.
Thus, our PF algorithm is summarized as follows:
(i) Generate the initial state vector {𝑍̂ 0[1] , … , 𝑍̂ 0[𝐿] }.
(ii) Apply the following steps (ii-a)∼(ii-d) to each time 𝑡 = 1, … , 𝑇 .
(ii-a) Generate system noise 𝑣[𝓁]
𝑡 , 𝓁 = 1, … , 𝐿.
(ii-b) Compute for each 𝓁 = 1, … , 𝐿, 𝑍𝑡[𝓁] = 𝐺(𝑍̂ 𝑡−1
[𝓁] [𝓁]
, 𝑣𝑡 ).
(ii-c) Evaluate the weights of particles {𝑍𝑡[1] , … , 𝑍𝑡[𝐿] } as 𝛿𝑡[𝓁] ≡
𝑝(𝑂𝑡 |𝑍𝑡[𝓁] ), 𝓁 = 1, … , 𝐿 by using the likelihood function.
(ii-d) Resample {𝑍̂ 𝑡[1] , … , 𝑍̂ 𝑡[𝐿] } from {𝑍𝑡[1] , … , 𝑍𝑡[𝐿] }. More pre-
′ Mendel, J., 2001. Uncertain Rule-Based Fuzzy Logic Systems: Introduction and New
cisely, resample each 𝑍̂ 𝑡[𝓁 ] , 𝓁 ′ = 1, … , 𝐿 from {𝑍𝑡[1] , … ,
𝑍𝑡[𝐿] } with the probability given by
′ 𝛿 [𝓁]
Prob.(𝑍̂ 𝑡[𝓁 ] = 𝑍𝑡[𝓁] |𝑂𝑡 ) = ∑𝐿 𝑡 [𝑚] , 𝓁 = 1, … , 𝐿.
𝑚=1 𝛿𝑡
10
Engineering Applications of Artificial Intelligence 100 (2021) 104154
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