Market Inefficiencies and Active Portfolio Management

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The Galiber Group, LLC

• Market Inefficiencies and Active Portfolio
  Management
• by
• Sorin Sorescu
• Associate Professor of Finance
• Mays Business School at Texas AM University
• Founding Partner, The Galiber Group, LLC
• Chicago Quantitative Alliance Conference
• Las Vegas, NV
• April 17, 2008

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Brief bio
The Galiber Group, LLC

• B. Eng. (1988) McGill University, Montreal, QC
• MBA (1991) McGill University, Montreal, QC
• Ph.D. (1996), Univ. of Florida, Gainesville, FL
• Faculty member
• Assistant Prof. University of Houston (1996-2002)
• Associate Prof. Texas AM University
  (2002-present)
• Founding partner, The Galiber Group, LLC (2007)
• Main research interests active portfolio
  management
• Research appears in JF, RFS, JFQA, JMCB, JIMF.

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Converting inefficiencies to alphas
The Galiber Group, LLC

• Factors that predict stock returns
• Short interest
• Value
• Profitability
• Reversal
• Momentum
• Risk management
• Optimal active portfolio management, different
  from modern portfolio theory

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Short interest predicts future returns
The Galiber Group, LLC

• Short interest
• Bullish signal?
• Bearish signal evidence
• Short sellers anticipate
• Poor earnings
• Bad news
• Short interest could serve as a quant factor

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Short Interest predicts month-ahead returns
The Galiber Group, LLC
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because short interest predicts future earnings

The Galiber Group, LLC
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and also future news
The Galiber Group, LLC
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Short sellers and manipulators
The Galiber Group, LLC
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Social benefits of shorting
The Galiber Group, LLC

• James Chanos of Kynikos Associates
• Shorted Enron before collapse
• Testified before Congress
• Despite two hundred years of "bad press" on Wall
  Street, it was those "unAmerican, unpatriotic"
  short sellers that did so much to uncover the
  disaster at Enron and at other infamous financial
  disasters during the past decade. Chanos
  testimony, 2/6/2002
• Regulation should facilitate shorting
  centralized market
• Short sellers could impose market discipline
  along side government regulation

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Fundamental Factors
The Galiber Group, LLC

• Value and Profitability
• The Little Book that Beats the Market (by Joel
  Greenblatt)
• Value (FCF/Market Value of Firm)
• Profitability (ROIC)

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Value predicts one-month ahead returns
The Galiber Group, LLC
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and so does profitability
The Galiber Group, LLC
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StockTrak Simulation at Texas AM
The Galiber Group, LLC

• Undergraduate investment class, Spring 2008
• Used a variant of the Little Book that Beats the
  Market strategy
• Long on high FCF/Firm Value and high ROIC
• Short on low FCF/Firm Value and low ROIC
• Period 1/11/2008 to 4/15/2008
• Top 15 firms long, bottom 15 short,
  market-neutral
• Trading every two weeks
• Market cap gt 1.5 Billion

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StockTrak Simulation at Texas AM
The Galiber Group, LLC

• Portfolio performance in real time (play money)
• 19.6 YTD return during 1/11/2008 to 4/15/2008
• -0.8 YTD total return for the SP 500 during
  same period

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StockTrak Simulation at Texas AM
The Galiber Group, LLC
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Technical Factors
The Galiber Group, LLC

• Momentum and Reversal
• Momentum
• Measured during t-7, t-1
• Reversal
• Measured during t-1, t

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Momentum predicts one-month ahead returns
The Galiber Group, LLC
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Stock prices reverse at short horizons
The Galiber Group, LLC
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Interaction of momentum and reversal is a more
powerful predictor
The Galiber Group, LLC

• Reversal is effective only for negative momentum
• Investors overweigh public news
• No reversal for positive momentum
• Investors underweigh public news

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Interaction of momentum and reversal is a more
powerful predictor
The Galiber Group, LLC
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Interaction of momentum and reversal is a more
powerful predictor
The Galiber Group, LLC
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Interaction of momentum and reversal A more
powerful predictor
The Galiber Group, LLC
Long
Short
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Active portfolio based on momentum-reversal
interaction
The Galiber Group, LLC

• Ignores transaction costs (commission and
  slippage)
• No risk management
• Pure alpha 44.4 per year
• Significant risk sigma 21.3 per year
• SP500
• Average return (with div) 17.8 per year
• Sigma 15.1 per year

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Active portfolio based on momentum-reversal
interaction
The Galiber Group, LLC
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Risk management
The Galiber Group, LLC

• Factor-based strategies
• Positive, large alpha
• High volatility
• To mitigate risk
• Eliminate small firms lt 1.5 B market cap
• Tradeoff between alpha and sigma
• Efficient frontier and minimum variance portfolio
  (Markowitz 1952)

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Efficient frontier with quant analysis
The Galiber Group, LLC
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Trading costs
The Galiber Group, LLC

• Commission
• Very high in the 1960s and 1970s (formula-based)
• Steady decrease through time
• Very competitive today
• Price impact of trade (slippage)
• High in illiquid markets (1974)
• Decreases through time
• Estimated using Amihuds measure
• Available on Joel Hasbrouck's website at NYU
  (stock-specific)

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The Galiber Group alpha strategy
The Galiber Group, LLC

• Back-test from July 1963 to March 2008
• Includes momentum, reversal, value and
  profitability factor categories
• 120/80
• Risk management at two levels
• Mid-caps and large caps
• Unique estimate of the minimum variance
  portfolio
• Careful estimate of trading costs
• Historical commissions
• Stock-specific price impact of trade

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Historical trading costs
The Galiber Group, LLC
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Back-test performance 1963-2008
The Galiber Group, LLC
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Back-test performance 1963-2008
The Galiber Group, LLC
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Back-test performance 1963-2008
The Galiber Group, LLC
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Back-test performance 1963-2008
The Galiber Group, LLC
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Conclusion
The Galiber Group, LLC

• Superior risk-return tradeoffs can be achieved
  with active portfolio management
• Significant risk reduction by combining quant
  factor investing with Markowitz portfolio theory
• More research needed on how to optimize tradeoff
  between risk, returns and trading costs.
• AM has plans for recurring conferences on active
  portfolio management (Dallas or Houston).