Thursday, November 17, 2011

Fabozzi and Markowitz, eds., Equity Valuation and Portfolio Management

Someday, I trust, markets will get a break from the relentless macroeconomic and political vicissitudes and investors will be able to focus once again on company and portfolio basics. In anticipation of that day Frank J. Fabozzi and Harry M. Markowitz have edited a very useful volume dealing with quantitative approaches to Equity Valuation and Portfolio Management (Wiley, 2011).

The book is broad in scope, as witnessed by the table of contents. Its 21 chapters include “An Introduction to Quantitative Equity Investing,” “Equity Analysis Using Traditional and Value-Based Metrics,” “A Franchise Factor Approach to Modeling P/E Orbits,” “Relative Valuation Methods for Equity Analysis,” “Valuation over the Cycle and the Distribution of Returns,” “An Architecture for Equity Portfolio Management,” “Equity Analysis in a Complex Market,” “Survey Studies of the Use of Quantitative Equity Management,” “Implementable Quantitative Equity Research,” “Tracking Error and Common Stock Portfolio Management,” “Factor-Based Equity Portfolio Construction and Analysis,” “Cross-Sectional Factor-Based Models and Trading Strategies,” “Multifactor Equity Risk Models and Their Applications,” “Dynamic Factor Approaches to Equity Portfolio Management,” “A Factor Competition Approach to Stock Selection,” “Avoiding Unintended Country Bets in Global Equity Portfolios,” “Modeling Market Impact Costs,” “Equity Portfolio Selection in Practice,” “Portfolio Construction and Extreme Risk,” “Working with High-Frequency Data,” and “Statistical Arbitrage.”

I can’t possibly do justice to the book in this brief post. Let me simply share a single idea that I found promising (and that can be sketched out in a couple of paragraphs).

It’s an approach for dealing with strategy failure. “Every investment strategy has three core properties: (1) the return that the strategy generates, (2) the volatility of that return, and (3) the correlation of that return with alternate strategies.” (p. 397) As we know, returns are fragile: “strategies fail despite the support of logic or history.”

To address this problem the authors, both from Nomura, suggest an alpha repair process. Essentially, what they do is to take a set of 45 factors (such things as 1-year price momentum, market cap, and ROE) and view each as an asset. “The objective is to own the portfolio of factors weighted to produce the highest Sharpe ratio.” They don’t want to include all 45 factors on the portfolio “team” because “while more factors could improve the Sharpe ratio by reducing risk, a diversified portfolio of many factors would likely produce lower returns than a concentrated portfolio of good factors.” (p. 403) Instead, they run their screens each month against a large pool of contending strategies and select three factors using optimization for next month’s “team.” The screens incorporate “the history of factor return, volatility, and correlation with other factor returns.” (p. 412)

The alpha repair strategy provides a framework for discarding a factor that seems to have lost efficacy and embracing one that seems to have become important. The procedure (which is of course a lot more complicated in its execution than in its bare outlines) has a targeted 100% annual turnover. It has outperformed the benchmark Russell 1000 in a consistently linear fashion—by more than 4% in the period January-August 2010, annually for the past five years, and annually for the past ten years.

No comments:

Post a Comment