Archive for the ‘Quantitative Analysis’ Category

Mutual fund
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Michael over at Marketsci asked a great question in his latest post – why do mutual funds continue to show no ability to think outside-the-box despite the abundance of alternative investment approaches that are available publicly (either from individuals or via public research) or from individuals that they could potentially hire to help run their fund (particularly in the quant area).  I thought I’d take a post and attempt to answer Michael’s question.

But first, a brief story.  In 2003, I was working in New York City at a start-up and just beginning my “quant journey” when our company was sold.  As Chief Technical Officer of the company, I was out of a job as there was someone at the new company that already held my position.  I was given a nice consulting contract and time to figure out what I was going to do next.  I was approached by one of the original investors my startup who was starting a hedge fund.  He felt my background in technology would make me a good analyst on technology-related stocks (I’d also told him I thought Apple was a buy in 2002 and he’d made a lot of money off that call).  When I told him I had no idea how to be an analyst, he offered to teach me.  Thus began what I can only describe as my on-the-job MBA training.  We were a fundamental-oriented shop, and I learn everything about fundamental analysis.  We did ok – not bad, not great.  And then my boss was offered a job at another fund, and he decided to shut down our fund and get started over at the other firm.  He’s done very well and is still one of the best investors I’ve ever met.

The question then, for me, was what to do next.  I wanted to get into another fund, but my background and experience was unorthodox to say the least.  A few years later I got an introduction, via a family friend, to a large mutual fund company that was looking for a small-cap analyst to join their team.  I was somewhat excited to go in – it would be a job in the right sector – but somewhat concerned about what it would be like working for a mutual fund.

I studied up on the fund for about two weeks.   The fund seemed to have changed strategies multiple times, and had now settled into a strategy of equal weighting sectors, and then using stock picking within each sector based on both quantitative measures and analyst recommendations.  It held 100 stocks across all the sectors.  All this sounds somewhat interesting, but the performance of the fund, to date, had been terrible.  An investor could have outperformed the fund in all time periods simply by buying and holding IWM.  Adding insult to injury, the fund had a huge sales fee of 2.75% (that’s an upfront cost to coming into the fund) and a very high expense fee for the fund itself.  So not only was the fund underperforming a simple index strategy, it was doing at a huge cost.

The interview itself was cordial but I knew, going in, that I was a long, long shot by any stretch of the imagination.  The fund manager asked me his first question: “how would choose stocks for this fund?”  I had given this question a lot of thought, and even run some simple tests to understand what the portfolio would look like.  I proposed to do a momentum ranking of sectors and then choose to overweight the specific sectors that were outperforming over a 12-month time period, and then select stocks within those sectors based on a variety of different criteria, including some fundamental-based quantitative measures as well as some price-based measures.  I then showed what the returns could potentially look like.

The fund manager didn’t seem to really care.  Perhaps it was because he felt the interview was pointless in the first place (because my background didn’t match with his expectation), or that he just so disagreed with my approach, but he then went on to tell me why my approach wasn’t appropriate and why he thought that their approach was superior.  Now, I chose not to be too confrontational with him on this because it was, after all, a family friend that had introduced me, and I didn’t think there was much to be gained by defending my approach too much.

But what I wanted to say to him was this: let me get this straight – you’ve underperformed the index since the inception of your fund while overcharging your customers for the privilege, and you’re telling me that my approach lacks merit? Instead I pointed out some issues with his current approach and refocused on the benefits of my approach – including citing research papers about the momentum effect.  Whatever – the interview was clearly over at that point as I could see him getting ready to move on in his day.

I asked him then what type of candidates they were looking for for the position.  He said that they were looking for someone with 3-4 years of buy-side experience or someone with 5-6 years on the sell-side (an MBA was pretty much implied here).  This was understandable at the time – getting someone from the buy-side to move over to this position in 2006, the height of the exodus from mutual funds to hedge funds, would be challenging – so he was mainly focused on the sell-side analyst community.

He ended by thanking me for coming in, and then suggested that my approaches seemed more appropriate for a hedge fund and that I should focus my job search in that area (remember that comment – I’m going to come back to that in a bit).

Ok – the story was supposed to be shorter and got longer – apologies – but I think this story demonstrates a lot of the issues with mutual funds today.  Let’s break them down.

  1. Small Gene Pool:  The mutual fund community generally hires people out of business school – not people with a background in sciences or any other background (Bill Miller’s degree in philosophy notwithstanding).  As a result, they’ve got a fairly homogeneous group of people that were all trained the same way.  The “craziest” they tend to get is to hire someone from the sell-side – which is interesting because the sell-side is a pretty good contrary indicator to stock performance in my experience.
  2. Reliance on a single approach: The mutual fund industry relies on the marketing idea that stock picking works (whereas research shows it rarely does) and that their particular group of analysts are the best stock pickers year after year.  Watch mutual fund commercials – they all have the same tone: “Experience, driven by the long term investment view, top team, etc.”  They all usually have the same kind of images as well – a team of people rowing together, or some sort of relay race, etc.  Yet any form of analysis of the industry shows the opposite – that any person would be better off with just a collection of index funds with low expense ratios.
  3. Strategy Scaling Requirement:  Mutual funds (and hedge funds) have a large issue in terms of scale.  For a mutual fund to make money – because they make their money on fees – they need to get big.  That means they can’t have very active strategies.  And it limits the companies they can invest in.  And it means that when they buy or sell, they are the “dumb money” – they tend to sell at the bottom and buy at the top because it takes them time to get into and out of a position.  In addition, many of the quantitative strategies that people put forward on the net (including my own) simply won’t scale to the size of a $1b fund.  For the individual investor, this is the advantage they have over these big lumbering giants.  The same is true for hedge funds as well – a friend of mine has a strategy where he simply invests in small hedge funds when they have less than $500m under management and exits when they get bigger than that – because he knows that funds are hungrier when they are smaller and can be more nimble.
  4. Belief that quantitative strategies are more risky: Remember the comment in the interview “maybe your approach would be more appropriate for a hedge fund” –  very interesting.  What he was saying, in my opinion, was actually “your strategy sounds riskier, therefore my clients will be scared” (It could also reference the scale issue mentioned above or that he thought I was a risky individual in terms of my background).  What he failed to understand (or even ask me about) was the risk-adjusted return.  He was just focused on the idea – not the result – as was obvious in the way he was running his own fund.  He was in love with the idea regardless of the results.
  5. Lack of a burning platform: So this fund was able to charge a 2.75% sales fee in addition to the yearly fee, underperform the market and still managed to have some customers?  What that tells me is that the people they’re selling this shit to are either not engaged in the world of investments (pension funds, individual 401k participates), in the pocket of the mutual fund company via some relationship, or they are just stupid.  So what, exactly, would be their incentive to change the way the fund was run?  Exactly – there was no incentive.
  6. Fully invested: This one is easy – most mutual funds have to be fully invested – keep their cash at a minimum amount.  This is a huge disadvantage over the individual investor.  Now, historically they’ve made the argument that timing the market doesn’t work and buy and hold is the way to go.  In general they are correct that most people cannot time the market.  However, if you buy into the buy and hold argument, then you’re still better off going with index funds.
  7. 100 stocks or more = Indexing: Most mutual funds (including the one I was interviewing with) have to hold a rather large number of stocks in order to scale.  In my experience, I’ve learned that approximately 60-65% of returns come from the general market, 20-25% come from the sector, and the remaining returns come from the individual stocks.  But if you’ve got over 100 stocks in a portfolio, you’ll discover that the portfolio starts to become very similar an index (assuming you’re doing equal sector weighting like they were).  So they were, essentially, a closet indexer with a high cost.
  8. Skepticism of quantitative price analysis:  This is a generalization, but I’ve found that most of the people that run mutual funds think that analyzing price action or using some other form of quantitative analysis is either voodoo or stupid.  To me, this is why James Simons over at Renaissance can eat their lunch while charging huge fees.
  9. Belief that they can out-perform the market:  This is a basic one but I think it should be stated – if you completely believe that you can outperform the market through fundamental stock picking, year after year, then that is your world.  If they would do any research on the subject, it would probably cause a cognitive dissonance so large that they would disappear into a deep depression.  Or they would say “fuck it, I’m making money off these chumps”.
  10. Belief that they can understand what is going inside a company:  Enron is an obvious example of this, but I see it all the time – these guys actually believe that they can fully understand these companies from the outside.  Even after SarBox has taken away many of their tools.  To me, what they are actually doing is guessing what is going on inside companies.  And you can never really know as is evident watching companies both beat and miss on earnings.  I can remember sitting at my desk at the hedge fund, waiting for an earnings release and realizing that I was just hoping the results would come out as I thought they would.  Hope, as they say, is a four-letter word.

I’ve rambled on enough in this post – I’d love to hear from readers as to what are other reasons that I may have missed.

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Parity - US Dollars Not Accepted
Image by Ian Muttoo via Flickr

Bill Luby at Vix and More seems to be stealing all my post ideas, but I’ll go forward with this one anyway.  Damn you, Bill!

In any case – like Bill, I’ve been spending time looking at the correlation between the US Dollar and Oil (and commodities in general).  Here’s a chart:


That’s the US Dollar at the top, followed by the Oil index, followed by the 100-day correlation of the two.  Almost perfect anti-correlation.  So, with that in mind, I’m watching commodities right now – and also taking a look at FXE as a way to play the dollar.  And, as Bill pointed out, I wonder if this is a strong sign of inflation reemerging due to the endless dollars we are printing to fund Bailout Nation.

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One Two Three Four Five Six Seven
Image by Thomas Hawk via Flickr

On a recent post on Marketsci on the use of RSI2, Bill Luby of VIX and More posted the following comment:

Count me among the fans of RSI (2). I think you might get more interesting results — though with much more time out of the market — using 95/5 and 98/2 as break points.

Also, if everyone is jumping on the RSI (2) bandwagon, perhaps it is time to spend more time evaluating RSI (3) or RSI (4) strategies. Just a thought.

Nice work, as always, but why do I always feel like I am assigning homework when I comment here…?

Well, I agree Bill – you can’t keep assigning homework to poor Michael.  I mean, where is the rest of the collective quantitative testing blogosphere when you need it?  Michael’s doing all the heavy lifting!  So to help Mike out, I’ve done some testing on different RSI days to see what would happen.  I can’t promise the snazy charts of Mike’s blog, but I’ll just break it down here quickly.

I created a basic system that buys the SP-500 when the RSI(N numbered day) goes below 10 and sells when it goes above 90.  You could do a further optimization of the actual buy and sell levels – I haven’t bothered to do that here.  I next optimized the system by having it run through different N numbered days.  So, RSI(1), RSI(2), RSI(3), etc.  Here’s the results:


So, as you can see, RSI(2) seems to do a lot better across a number of metrics.  These include Expectancy, Sharpe and a few others.

Now, what if we altered the RSI days for both entry and exit – meaning, say we enter on RSI(3) < 10 but exit on RSI(4) > 90.  How does that look?


So once again, we see that RSI(2) seem to win across a number of factors.  Will this hold true in the future?  Who knows. Couldn’t you break it down further by period?  Absolutely.  But maybe I’ll leave something for Michael to do – the guy is so friggin’ lazy.  😉

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Nick Gogerty over at designing better futures (via Worldbeta) has an excellent post on the importance of not losing money.  Here’s the chart and the money quote:


The acceleration point for losses requiring greater gains is around a 13% loss.  Think of it as inverting the power of compounding returns.  Currently the S&P is 26% below it highs.  To get back to the previous high point for domestic investors the S&P 500 needs to gain a little over 35%. The long term +80 year historical average return for equities is around 7-8%, so back to break even then in around 4 years.  Based on historical average return would be 2012-2013.The ex dividend annual return for the S&P for a dollar based investor since 1998 has been roughly .3%.  When one factors in an inflation estimate of 2.5% per year, one ends up with an effective loss of purchasing power of 25% over the last decade.  Welcome to the lost decade.

His point is well taken – that when you consider being down 20%, it will not be a 20% gain that takes you back to parity.  Once you cross the 13% rubicon, you’re into needing a huge amount to recover.   This is why I am interested in different approaches to investing – consider that some people who invested in the Nasdaq during the dot.com boom are still underwater.

But what really got me was when he laid it out in terms of time given an average equity return – 4 years to get back the gains.  Now, obviously the S&P has had returns greater than 7% in any given year, but we’re talking average returns which might well be what we are in store for over the next decade (as readers know, I’m not a predictor of future returns).  Nick’s blog has some other great posts and thus will go into the blogroll.

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XHB (Homebuilder’s ETF) showed up on my RSI2 scan – and then I looked at a Bullish % Index I constructed in Bull’s-Eye Broker a while back. I think it’s pretty compelling. Now, the ATR on it is quite large – so I’d be taking a fairly small position. Here’s a picture of the Bullish %:

XHB Bullish %

When it’s down in the sub-20 range, it’s usually a buy. Between that and the RSI2 signal, I think it’s an interesting long.

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I read a lot of economic blogs, mainly because I find the subject interesting.  But I ignore them in terms of my trading/investing.  Why?  Because most of the time, sadly, their reporting is not actionable.  It can range from interesting information to paranoia – particularly on certain websites such as Bill Cara’s website.  Now I know some people, perhaps Bill himself, will find his way to my website and say “hey, I’m not paranoid, this is really going on!!!”  And that may or may not be true.  Plunge Protection Teams, interest rate cabals, the US causing 9/11 and AIDs – it all might be true, but it doesn’t help me on a daily basis.

Mish’s Global Economic Trend Analysis has a lot of interesting posts – like this one.

Here’s a great quote from the article:

“What we are experiencing is a demand shock coming from a new category of participant in the commodities futures markets: Institutional Investors. Specifically, these are Corporate and Government Pension Funds, Sovereign Wealth Funds, University Endowments and other Institutional Investors. Collectively, these investors now account on average for a larger share of outstanding commodities futures contracts than any other market participant.”

Now, this may be what is really causing the rise in commodities.  Seems to make sense to me.  But the question is how do I profit from this information?  Does that mean this trend is on-going?  Or is it about to come to an end?

In contrast with this, my MOMO1 system has been long OIL since 4/2/08.  The system has picked up on this momentum.  Now, like most momentum systems – momentum giveth and it taketh away.  So I fully expect OIL to give up some gains at some point.  The position is up about 24% after being up as much as 29%.

So what am I concentrating my time on?  Figuring out how to make my MOMO1 system unload holdings at the top – now that’s something to spend time on.

In short – stop worrying about what you cannot control – focus on what you can control.

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