Tag: investing

Cliff Asness on Momentum Investing

In a wide ranging interview with Tyler Cowen, Cliff Asness discussed momentum and value investing strategies, disagreeing with Eugene Fama, the economics of Ayn Rand, bubble logic etc. The first half of the conversation was mostly about momentum investing and how it works.

Excepts on momentum:

Intro
A momentum investing strategy is the rather insane proposition that you can buy a portfolio of what’s been going up for the last 6 to 12 months, sell a portfolio of what’s been going down for the last 6 to 12 months, and you beat the market. Unfortunately for sanity, that seems to be true.

To some, it’s very intuitive. Just buy what’s going up.

Drawdowns
It has horrible streaks within that of not working. If your car worked like this, you’d fire your mechanic, if it worked like I use that word. I think it is harder than you might guess, even if something works long term, to have it go away because a lot of investors can’t live through the bad periods. They decide why it’s never going to work again at the wrong time.

Why it works
Underreation: News comes out. Price moves but not all the way. People update their priors but not fully efficiently. Therefore, just observing the price move is not going to move the same amount again but there’s some statistical tendency to continue.

Overreaction: People in fact do chase prices.

How to make it work
If you’re going to be momentum, you’ve got to really do it. You’ve got to be disciplined. You’ve got to come in every day, and you’ve got to count on these under- and overreaction things.

Momentum strategies on StockViz

We have been offering the Momentum Theme for more than two years now. It implements a relative momentum strategy where you compare the strengths of a universe of stocks to each other. 2014 returns were +90% and +36% so far this year (Compare.)

This year, we have introduced Velocity – an absolute momentum strategy – and Acceleration – a strategy that tracks changes in momentum.

If you are interested in momentum investing, please get in touch with us!

 
Source: A Conversation with Cliff Asness
Related: Small Cap Momentum Style Fund

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Will Your Strategy Outperform?

Came across an interesting paper: Will My Risk Parity Strategy Outperform? Robert M. Anderson, Stephen W. Bianchi, CFA, and Lisa R. Goldberg. Even though they discuss risk parity, they make some pretty interesting points that relate to all investment strategies.

Today’s alpha is tomorrow’s beta

… the introduction of new securities can have an indirect effect; a strategy that was seemingly profitable in the past might have been less profitable if the new securities had been available and thus made the strategy accessible to a broader class of investors.

Before index ETFs, there was no cost-effective way of replicating an index. For example, NIFTYBEES was listed in 2002 and came with an expense ratio of 0.80% while retail brokerage charges were in the 0.5-1.0% range. Replicating the NIFTY index before NIFTYBEES came around was expensive. So any backtest before 2002 that that tries to argue the benefits of buying-and-holding an index ETF is likely bogus. Similarly, today’s active management strategies available to a select few hedge-fund investors are tomorrow’s “smart beta” ETFs that will be available to anybody with a demat account.

Leverage is an external source of risk

The notion that levering a low-risk portfolio might be worthwhile dates back to Black, Jensen, and Scholes (1972), who provided empirical evidence that the risk-adjusted returns of low-beta equities are higher than the CAPM would predict.

There are periods when banks pull their lines of credit based on macro factors that has nothing to do with your strategy. For example, during the 2008 financial crisis, your bank/broker would have pulled your credit lines forcing you to sell near the bottom and preventing you from buying the bounce. Any strategy that uses leverage – risk-parity, for example – should factor this risk.

Performance depends materially on the backtesting period

Even if we were reasonably confident that one strategy achieved higher expected returns than another without incurring extra risk, it would be entirely possible for the weaker strategy to outperform over periods of several decades, certainly beyond the investment horizon of most individuals…

Besides, most strategies have a rebalancing frequency – once a month, once a year, and so on. The specific day you choose to rebalance can have a material impact on your strategy. For example, rebalancing during options expiry, corporate events, etc… can meaningfully skew your risk/returns.

Borrowing and trading costs can negate outperformance

Value-weighted strategies require rebalancing only in response to a limited set of events. The risk parity and 60/40 strategies require additional rebalancing in response to price changes and thus have higher turnover rates. Leverage exacerbates turnover.

There is huge execution risk involved in strategies that requires shorting of shares. Given the regulations surrounding SLBS – lending/borrowing allowed only on those securities that are listed in F&O and that too only in increments of lot-sizes – the friction involved in shorting stocks are prohibitive.

Execution drift

There is likely going to be a big difference between model execution prices and actual execution prices. For example, when we rebalance our Themes, we use the latest available price in our database. These prices themselves could be stale by over 10 minutes. These changes then have to percolate down to investors who execute them in the market. From start to finish, there could be a price gap of over 20 minutes – a significant source of drift between the ideal P&L and actual P&L.

Conclusion

Investors should have a deployment checklist for their strategies that addresses the issues raised above. What we have found is that most strategies that look good on a simple backtest don’t look that great when costs, variable periods, drift and half-lives are factored in.

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Profiting from PE Ratio Obsession

Background

We are not big fans of using the Price-to-Earnings ratio. We saw how funds that use the market PE to time the market are no better than a buy-and-hold strategy (sometimes B&H performs better,) and we followed that up with how every single “ratio” has a caveat. And PE is the dumbest of them all.

However, if a large group of market participants pay attention to single flawed metric, then there should be a profitable arbitrage strategy that exploits that anomaly?

Exploiting PE obsession

Researchers in the US figured out a way to do just that.

Active investors with limited attention and capital constraints use fundamental metrics to screen and sort potential investments. Price-earnings (P/E) ratios are extremely popular, and are typically calculated using four trailing quarters of net income. Changes in the rankings of published P/E ratios may influence investor attention and subsequent excess returns. From 1974-2013, decile long-short portfolios formed on characteristics of P/E rankings which are rebalanced monthly earn value-weighted monthly excess returns of 101 basis points with annual Sharpe ratios of 0.79. Decile long-short portfolios which are rebalanced daily earn value-weighted daily excess returns of 16.99 basis points with annual Sharpe ratios of 2.91. Excess returns are robust to size, value, profitability, investment, price momentum, earnings momentum, short-term reversals, and relative volume. Changes to a stock’s P/E ranking predicts excess returns even when the stock’s P/E ratio itself does not change. The return premium cannot be explained by fundamental risk, clustering of attention at round number P/E ratios, or autocorrelation in the regressors.

We haven’t tested this for the Indian market yet. But this is just too cool not to share!

Paper: Rankings of published price-earnings ratios and investor attention

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Beware of Single Factor Investing

Factors are short-cuts

Analyzing financial statements is a cumbersome process for most retail investors. Many don’t have the time, patience or expertise to dig through balance-sheets, income and cashflow statements. Most don’t find joy in reflecting on the many footnotes that accompany such statements. Here lies the attraction of single-factor investing.

Price-to-Earnings (PE) ratio is one such factor. We recently saw how there was no great advantage in investing in mutual funds that use PE to switch between debt and equity. It is a poor market timing indicator even when practiced by professional fund managers.

The ‘E’ in PE

The ‘earnings’ line-item is an accounting driven artifact that is easily gamed and has very little relationship with the company’s value. Here’s what Michael J. Mauboussin has to say about earnings, see appendix for the full note:

… an increase or decrease in earnings does not provide a clear picture of the corresponding increase or decrease in shareholder value. This is because the earnings figure does not reflect the company’s level of risk, does not take into account the investments needed for anticipated growth, and is subject to a wide variety of accounting conventions. Such accounting conventions do not ordinarily affect cash flow and hence do not affect a company’s value.

Even Shiller’s cyclically-adjusted P/E (or “CAPE”) has little predictive value in the short term. Shiller CAPE shows its strongest correlation to nominal returns over an 8-year time horizon, and is actually most predictive of real returns over an *18* year time horizon. (Kitces)

Some investors also look at Price to Book and Return on Capital Employed. These ratios provide a convenient short-hand but are far from adequate in forecasting future earnings.

Besides what does the ratio of total assets to total liabilities measure anyway? Intangibles can’t be quantified. Are inventories adjusted to current market prices? Is the loan loss reserve adequate?

Bottom line: Assets are often overstated and liabilities understated. (Fool)

What does “capital employed” mean anyway?

  1. No general agreement exists on how capital employed should be calculated, on whether initial or average capital employed should be used or on how profit should be defined.
  2. Often, accounting profit rather than cash flow is used as the basis of evaluation.
  3. It ignores the time value of money.

Take away

Every style of investing – value, momentum or factor – depends on finding historical patterns and extending them into the future.

Every valuation metric comes with a “yes, but…”

No single factor is a predictor of future returns.

Appendix

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Are Dividends Anti-Shareholder?

Dividends vs. Buy-backs

When firms are left with excess cash, they have the option of distributing money back to shareholders by either issuing dividends or buying back their stock.

All things being equal, investors should be indifferent whether a company pays dividends or engages in a buy-back.

The dividend irrelevance argument

The underlying intuition for the dividend irrelevance proposition is simple. Firms that pay more dividends offer less price appreciation but must provide the same total return to stockholders, given their risk characteristics and the cash flows from their investment decisions. Thus, there are no taxes, or if dividends and capital gains are taxed at the same rate, investors should be indifferent to receiving their returns in dividends or price appreciation. (Source: NYU)

Indian Taxes

In India, long-term capital gains in equity investments attract zero tax. Long-term is one year. However, there is a dividend distribution tax of around 28%. So if a company decides to pay Rs. 100 in dividend, only Rs. 72 reaches the shareholder.

In this scenario, companies that declare dividends are taking a step that is against the interests of the share-holder. Investors are better off if the company buys back stock from the open market instead.

Here are some of the largest dividend payers:

2015 2014
TCS
17020.50
5480.10
INFRATEL
1682.20
566.60
VEDL
3106.30
2214.40
ITC
4875.60
4238.60
WIPRO
2949.00
2327.30
HDFC
2505.90
1939.90
HINDUNILVR
2918.90
2495.60
TECHM
549.60
135.90
ICICIBANK
3084.10
2704.00
HINDZINC
1878.50
1532.50
The figures are in Rs. crores and nearly 1/3rd of this goes to the tax-man.
One wonders if these companies are working for the Indian government instead of the shareholder.

Conclusion

Small investors and fund managers should demand that the boards consider buy-backs over dividends.

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