Strategies at Work

A quick update on how some of our strategies have performed during the Corona Virus Panic and some exciting extensions in the works.

Factor Momentum

We introduced Factor Momentum in our newsletter Factors - Risk and Returns. The basic question was: can factors (value, momentum, quality, etc.) be timed? We had run a backtest at that time and setup Themes along those lines.

While it worked great for US stocks, it didn’t offer much downside protection during the Corona Virus Panic in the Indian markets.

When we dug through the differences between how our US and Indian strategies were setup, we realized that US benefited from having bonds in the mix while the Indian strategy was setup to be equities only. To make them comparable, we added NIFTY GS 8 13YR index, representing long-term bonds, as one of the factors to our Theme.

Read it here: 90 days of Factor Momentum

Optimized Portfolios

We introduced portfolios that were optimized to have minimum volatility in our newsletter Optimized Portfolios. We setup four Themes tracking min-ETL/min-Var optimizations over unfiltered and momentum stocks.

We are a fan of the momentum min-vol (min-ETL/min-Var) strategies. Equal-weighted momentum is too volatile - we believe that optimizing for lower volatility results in superior outcomes for the investor over the long term.

Read it here: 90 days of Minimum Volatility

While the above Themes are as close to theoretically pure as you can get with these strategies, there are a couple of problems worth noting. One, they are rebalanced once a month but the market doesn’t move evenly throughout the month to keep our models sane. However, if you rebalance too often to track market volatility, then your costs go up. And two, sometimes the optimization process fails to produce a result. Typically, either min-ETL or min-Var fails or one of them outputs a 100-stock portfolio. To overcome these two problems, we setup a unified Theme that toggles between both min-ETL and min-Var based on our measures of practicality and rebalances only if it makes “sense.” Stay tuned for updates.

Risk Management

As the Corona Virus Panic devastated portfolios, one thing became apparent - most investors do not understand that risk management is not free. You pay for risk management in terms of reduced returns throughout the life of the investment. It is not a one-time cost and neither can it be timed. Investors need to decide on a risk management policy that they can live with and stick to it.

Risk management strategies can either be endogenous (part of your portfolio) or exogenous (outside your portfolio.) For example, the min-vol optimized portfolios discussed above or a 60/40 equity/bond portfolio is endogenous. Explicitly hedged portfolios or using a trailing stop-loss on the entire strategy is exogenous.

A portfolio without risk-management could very will out-perform the markets during a bull but will get thoroughly mauled by a bear.

Read: Risk Management is Not Free (Part I, Part II, Part III)

Hedging Optimized Portfolios

A typical hedging strategy involves calculating the beta of the portfolio over an index and shorting the index as a proportion of that beta. However, if you have a high beta portfolio, say beta = 2, then to fully hedge it, you will have to short 2x the size of the portfolio. Given that the long-run excess returns of most equity factors is in the 2-3% range, hedging such a portfolio will result in negative net returns for the investor.

Turn this around on a low-beta portfolio, say beta = 0.5, then a full hedge doesn’t overshadow the portfolio. And since beta is low already, you could probably get away with hedging partially. This keeps a lid on costs and leaves a fair amount of portfolio excess-returns intact.

We have a couple of interesting things going on in this space. Stay tuned for more!