Multi Factor Quant Market Neutral Equity

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Multi Factor Quant (Market Neutral) Equity

Kevin ColdironAlgert Coldiron Investors, LLC
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Agenda

• Introduction to the strategy
• Forecasting (relative) returns
• Building a portfolio
• What does market neutral mean?
• What happened in August?

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Quant Philosophy

• Opportunities arise because of
• Biased decision making by investors
• Institutional constraints
• Risk management win by not losing
• Recognize what youre not good at dont bet on
  those things
• Quantitative tools
• Identify and measure opportunity set
• Ensure consistent decision making

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Why Quantitative Tools Help

• Humans
• Smart
• Poor communicators
• Emotional
• Computers
• Dumb
• Effective communicators
• Even-keeled

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Forecasting ReturnsExploit decision patterns of
other market participants

• Under-reaction to news in the short term -
  creates momentum/trending
• Over-reaction to news in medium term - creates
  mis-valuations
• Anchoring on simple metrics - creates potential
  for being misled or manipulated
• Non-investment constraints imposed by
  institutional investors or by asset manager on
  themselves

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Investment Process Overview

• (1) Create factors that proxy for the
  behavioural patterns you are trying to exploit
• (2) Rank all stocks ranking becomes your
  expected return
• (3) Design the portfolio
• Position size function of stocks rank and risk
• (4) Trading
• Deserves its own presentation
• Easy to squander good work in steps 1-3

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Example Creating an Under-Reaction score
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Example Creating an under-reaction score
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Example Creating an under-reaction score
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Example Creating an under-reaction score
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Ranking All Stocks Together
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Ranking All Stocks Together
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Simple IdeaBut

• Important questions hidden beneath the surface
• How do you design and test the factors?
• Do you only consider historical performance?
• How much data do you consider?
• Should the factors be the same in each sector?
  Region?

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Highlights Differences Between Quants and
Traditional Stock Pickers

• Quants
• Use judgement/skill to answer questions on
  previous slide
• Take emotion out of the buy sell decision
• Lower hit rate but more coverage
• Stock pickers
• Apply judgement/skill to the buy sell decisions
• Sacrifice breadth for depth

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Portfolio ConstructionMaking It Market Neutral

• Hedge out risks that you are not explicitly
  forecasting
• Market, Industry, Size, Country
• How do you do this?
• Example
• Cash 100m
• Dollar Value of Shorts -100m
• Dollar Value of Longs 100m
• Fund Value 100m

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Example Industry Exposure for Sample Market
Neutral Portfolio
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Example Industry Exposure for Sample Market
Neutral Portfolio
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Pause For Breath

• Forecasting Relative Returns
• Good fundamental analysis done systematically
  across large numbers of names
• Breadth, not depth
• Designing Portfolio
• Most funds try to be neutral to absolute
  changes in market, industry, size, etc

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What Happened in August 2007?

• Negative returns across almost all quantitative
  equity strategies, particularly those focused on
  US
• Several stories (not mutually exclusive)
• Unwind Story
• Banks/hedge funds suffered losses on credit
  portfolios and needed to raise cash.
• Cash was quickly taken out of quant strategies to
  fund these losses
• This trading triggered losses among other quant
  managers
• These losses required managers running with very
  high leverage to post more margin
• They did this by closing long and short positions
• This trading further intensified and spread the
  losses
• Ultimately a vicious cycle ensued particularly
  on August 2-9th
• There was a very sharp bounce bank from August
  10th
• We estimate at least 100bln of long and short
  positions were closed in 12 days

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Why?

• Long period of success drew in many new
  participants
• Capacity estimates failed to account for what
  others were doing
• Many of the newer participants
• Using very high levels of leverage
• Not committed to quant strategies as business -
  they were easiest to close from a business
  standpoint when capital became scarce
• Over-crowding focused on US
• Buy hold returns across the whole month were
  not unusual outside the US

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The Future for Quant Equity

• Short-term tug-of-war
• Headwind as money flows out of the space via
  redemptions
• Set against opportunities created by exposure
  unwinding
• Long-term
• Less crowded space overall
• Far fewer (if any) participants running the
  strategy like a short-term prop trading portfolio
• Other arbitrage strategies have experienced
  similar episodes and survived
• Fixed Income (1998), Convertible Bond (2005)
• MA Arbitrage and Statistical Arbitrage

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Summary

• Picking Stocks
• Familiar investment themes, but executed
  systematically
• Take emotion out of buy sell decision
• Portfolio Design
• Win by not losing
• The Future
• Smaller space, less leverage, higher returns(?)