Author: shyam

Factor Rotation

Is there a away to time factors?

Factor investing is the process of constructing portfolios of stocks by isolating certain statistical properties that have shown to out-perform over the long term. For example, investing in stocks that rank high in the “Quality” factor. Here are some factors that were discussed previously on FreeFloat:

  1. Introduction and Fama-French 5 Factors.

  2. Momentum investing.

  3. The Low-volatility Factor.

No Holy Grail

While factor portfolios are expected to out-perform over the long-term (say, 30 years,) there is a strong chance that they under-perform over an individual’s holding period (5-10 years.) This leads to sub-par investment returns due to out-of-favor factors.

For example, Value vs. Growth.

Is Value/Growth Dead?

Consider IWD, the iShares Russell 1000 Value ETF, IWF, the iShares Russell 1000 Growth ETF and IWB, iShares Russell 1000 ETF.

2000 through 2010, value out-performed.

2010 through 2020, growth out-performed.

Whether you were a “Value” investor or a “Growth” investor, you saw 10-years (!) of under-performance.

Persistence of Out-performance

To avoid under-performing, an investor can:

  1. Market-cap index (avoid choosing.)

  2. Predict (good luck with that.)

  3. Follow the herd (FOMO.)

Turns out, option #3 works pretty well and is robust.

Individual factors can be reliably timed based on their own recent performance.

Factor Momentum Everywhere – Tarun Gupta, Bryan T. Kelly (AQR)

Rule: Buy whatever worked in the last month

Worked in the US

Worked in India

The problem, however, is that India has STT (Securities Transaction Tax) that the US doesn’t. And with a high turn-over strategy, STT can completely sap whatever alpha was produced.

Rule: Buy the one with the Best Average Returns over the last 6-12 months

Worked in the US

Worked in India

Forward-Test

The back-test showed that for the US markets, investors can rotate into the factor that performed the best in the last month. And for India, investors can average into the one that had the best average 6-12 month returns.

US

The Factor Momentum strategy beat plain-vanilla momentum (MTUM) and S&P 500 (SPY). It also avoided the Corona Cliff in March 2020.

India

The Indian version of the Factor Momentum strategy is a mixed bag. Since it averages over a longer time-period, it is (understandably) slow to respond to sudden events. The dive during the Corona Cliff and subsequent performance is inline with the back-test. Thus far, it has marginally out-performed NIFTY 50 and MIDCAP 100 after STT and brokerage and we remain optimistic about its future.

Conclusion

Factor Rotation holds promise. Research, back-tests and forward-tests confirm. The trade-off is pretty clear as well: shorter look-backs/shallower draw-downs vs. transaction costs. Since trading US equities is nearly friction free, investors can use shorter look-backs. Indian investors will have to stomach deeper draw-downs given transaction taxes.

Categories Tags

Factors

Some portfolios you consistently ended up with higher returns, implying that there was something about the market, something systematic, that was driving them. What are these factors? Factors, Intro

Systematically accounting for excess returns became an academic sack race. Factors, The Famous 5

While fundamental factors play a role in explaining excess returns, technical factors cannot be ignored either. Thus, Momentum. While the market can be sliced-and-diced in many different ways, here’s a simple way to go about it: The All Star Backtest.

Most momentum strategies use a skip month. What happens if you don’t? And what happens if you skip two? Does it make sense to rebalance weekly?

Momentum portfolios are extremely volatile. But, is it possible that a portfolio of less volatile stocks out-perform the market? Ergo, the Low Volatility Anomaly.

Turns out, you can boost returns of a low-volatility strategy by adding a bit of momentum. VOLxMOM.

Both Factor Rotation (buying what worked best in the past) and Multi-Factor (buying all factors) work. As long as you stick with it.

Categories

The Low Volatility Anomaly

More returns for less risk

Our previous post on Momentum highlighted the inherent cliff-risk in the “buy-high, sell-higher” strategy. But even before Fama French published their 3-Factor paper, researchers had found that the “high risk = high reward” relationship is quite fragile. In 1972, Haugen, Robert A., and A. James Heins, studying the period from 1926 to 1971, came out with a working paper – On the Evidence Supporting the Existence of Risk Premiums in the Capital Market (ssrn) – that concluded that over the long run stock portfolios with lesser variance in monthly returns have experienced greater average returns than their ‘riskier’ counterparts (wikipedia).

Basically, a portfolio of low-volatility stocks will out-perform the market. More returns for less risk.

What Explains the Anomaly?

There are two main trains of thought on why this anomaly persists.

  1. It is difficult to short high-beta stocks and buy low-beta stocks. Because, if it were easy, one could construct a zero-beta portfolio with positive expected returns… and this anomaly would vanish.

  2. Stocks of companies with predictable earnings exhibit low-volatility. So, low-volatility is essentially high-quality – a known investment factor.

Historical Performance

While low-volatility has out-performed market indices, it is magic wand that makes drawdowns disappear.

India

US

Risks

The biggest risk in a portfolio of low-volatility stocks is that a large proportion of it could be held by weak hands – investors who are drawn to it primarily because of its low-volatility. And when faced with a drawdown that is steeper than historical experience, they can simultaneously head for the exits, resulting in a cascading drop in price. The triggers could be a missed earnings estimate, an industrial accident, etc. While momentum investors are used to being routinely hit in the head, a small shove can push low-volatility investors down a cliff.

Portfolio Construction

A portfolio of low-volatility stocks vs. a low-volatility portfolio of stocks.

While initial research focused on stocks that had low-volatility, a collection of low-volatility stocks can result in a portfolio with high-volatility if the correlations among them are high. To illustrate, consider two low-volatility stocks who’s volatility varies through time like this:

If you put them in the same portfolio, what happens to the portfolio volatility?

Now, what if you picked two stocks whose volatility were inversely correlate? In theory, you can mix to high-volatility stocks and get a low-volatility portfolio.

Resulting in:

Source: Low Volatility: Stock vs. Portfolio, StockViz

Min-Vol vs. Low-Vol

A Min-Vol portfolio tries to optimize the overall portfolio volatility. A completely different approach to having a portfolio of Low-Vol stocks. In the US, there are two large ETFs that track these different approaches: USMV – the iShares Edge MSCI Min Vol USA ETF, and SPLV – the Invesco S&P 500 Low Volatility ETF.

It appears that Min-Vol has an edge over Low-Vol in most scenarios.

Conclusion

While Momentum of Min/Low Volatility can appear to be diametrically different strategies, there are ways to mix them up in the same portfolio to achieve a lower-volatility momentum or a higher-return-low-vol outcomes.

However, at the end of the day, retail investors will forever be at the mercy of market beta. So, irrespective of which flavor of jam you like, the kind of bread you eat makes the biggest difference!

Enjoy the discussion:

Categories Tags ,

The All Star Backtest

Profit by investing in stocks that have hit their all time highs

We launched the All Star Portfolio last week along with our discussion on momentum strategies. It is a great way for investors new to momentum (or equity investing, in general) to follow along a systematic momentum portfolio. We like this particular strategy because:

  1. Lower risk compared to other momentum strategies.

  2. Go-to cash if there aren’t viable candidates.

  3. A wide trailing stop-loss to exit outliers.

  4. Works with top-300 stocks by market cap – doesn’t depend on small caps to drive performance.

  5. Lower churn compared to other momentum strategies.

Historical Performance

We start from 2010 and rebalance monthly. Observe the drawdowns and the relative out-performance of the All Star.

The reason for the lower drawdowns is the ability of the strategy to stay in cash when things are bad. While we can take up to 25 positions, the slots are not always filled. An equal weighted portfolio (4% per slot) with only 5 positions will have 80% in cash.

Moreover, the per-position max loss during the time frame has been less 10% in a given month.

By keeping a trailing stop-loss of 15%, we ensure that only the true outliers are caught by it and not the run-of-the-mill corrections that are bound to happen.

Categories Tags

Book Review: Trade Wars Are Class Wars

In Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace (Amazon,) authors Matthew Klein and Michael Pettis argue that a handful of elites have captured the financial benefits of open global trade and finance. This has caused a global savings glut and a hunt for safe assets that has resulted in a series of boom-busts in American asset prices and an hollowing-out of its manufacturing base. These underlying income and wealth inequalities have manifested themselves as trade wars.

Excerpt:

Trade war is often presented as a conflict between countries. It is not: it is a conflict mainly between bankers and owners of financial assets on one side and ordinary households on the other—between the very rich and everyone else. Rising inequality has produced gluts of manufactured goods, job loss, and rising indebtedness. It is an economic and financial perversion of what global integration was supposed to achieve.

America’s openness to international trade and finance means that the rich in Europe, China, and the other major surplus economies can squeeze their workers and retirees in the confidence that they can always sell their wares, earn their profits, and park their savings in safe assets.

The world’s rich were able to benefit at the expense of the world’s workers and retirees because the interests of American financiers were complementary to the interests of Chinese and German industrialists. Both complemented the interests of the wealthiest throughout the world, even from the poorest countries.

The book is an easy read and anyone who is interested in understanding the current macro environment should read it.

Recommendation: Read it Now!

Categories Tags ,