Cqa intro only cu 2016 08 24

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CQA Investment Challenge • Quant Methods in Long/Short Equity Investments

• Jon Tesseo- Signal Analytics • Trent Ambler- Trepco Capital Partners

This class provides an introduction to various portfolio management and investing techniques with particular emphasis on methods that contrast and enhance traditional long-only, qualitative approaches _ Long/Short _ Market Neutral _ Quantitative Methods

_ Alpha Modeling

Introduction

Learning Objectives and Format

_ Risk Forecasting and Management _ Attribution _ Applied Equity Portfolio Management (we will be running a live, paper traded, portfolio) _ Simulated Client Interactions

_ ‘Out of Sample’ Strategy Implementation and Testing

CQA Investment Challenge To better facilitate the development of marketable, “real-world” finance skills we will be participating in a live investment challenge _ Challenge Runs Oct. 31st – March 31st _ Market Neutral/$ Neutral Equity Long – Short _ $10mm AUM Paper Portfolio _ Quantitatively Driven

Deliverables Client ‘Pitch’ – This will either be a mock RFP or Video Presentation Due Mid December ‘Quarterly’ Report – Summary of Performance, mock client communication Due Late Feb

JT & TA, Fall 2016

The Chicago Quantitative Alliance (CQA) is “a professional investment organization comprised of leading quantitative investment practitioners. The CQA membership includes investment managers, plan sponsors, consultants, and other investment professionals. The primary goal of the CQA is to facilitate the interchange of ideas between quantitative professionals.” _ Roughly 1,000 Member organization, Membership is intentionally limited and Highly Selective _ Membership representation from many of the top quantitative investment firms and service providers (AQR, LSV, Quantitative Mgmt Associates, PanAgora, CapitalIQ, Axioma, Barra, Northfield, etc…)

Introduction

Chicago Quantitative Alliance (CQA)

_ The competition offers students from top U.S. and International Academic programs the opportunity to compete, winning teams are invited to CQA Conference and will have resumes circulated amongst CQA membership

Scoring _ Weighted Sum _ 40% Sharpe Ratio _ 20% Absolute Return _ 40% Client Deliverables

Participating Schools Over 30 Participating Schools in 2015 Competition

Constraints _ _ _ _ _ _

Market Neutral +/- 0.50 Dollar Neutral +/- 5.0% Max Leverage 2:1 Fully Invested (<5% Cash) 5% Maximum Position Size US Large Cap (Russell 1,000) JT & TA, Fall 2016

_ What do Short sellers do??

Introduction

Mechanics of a Long/Short Market Neutral Fund, Shorting

_ Are these actions Useful/Desirable??

Shorting Equities, Definition Basic Definition: Short Selling involves the sale of a security that is not owned by the investor. Short sellers seek to profit from declining asset prices. Because short sellers do not own the security that is being sold they must Borrow the security before it can be shorted. There is an active securities lending market in the U.S. that facilitates this process – owners of securities agree to lend their holdings and receive collateral and a fee in return.

JT & TA, Fall 2016

Short sellers endeavor to identify assets for which the market price is decidedly disconnected from fundamental value and profit from this disconnect through the execution of a short sale. The aggregate action of short sellers enhances the market price discovery mechanism and actually benefits the capitalistic system by facilitating the efficient flow of capital to productive assets.

Broken Business Model

Shorting Equities, Definition Basic Definition: Short Selling involves the sale of a security that is not owned by the investor. Short sellers seek to profit from declining asset prices. Because short sellers do not own the security that is being sold they must Borrow the security before it can be shorted. There is an active securities lending market in the U.S. that facilitates this process – owners of securities agree to lend their holdings and receive collateral and a fee in return.

Introduction

Mechanics of a Long/Short Market Neutral Fund, Shorting

Overvaluation

Fraud

Shorting Equities, Challenges _ Return Asymmetry, losses are theoretically unlimited while gains are capped at 100%

_ Upward Bias in the Market, short sellers are fighting equity risk premium that is positive in the long run _ The psychological fortitude of the manager and the investors is important, Short Sellers are often lonely and are frequently vilified _ Legal and Tax _ Losing positions increase in Wt. (%) _ Short Squeeze

JT & TA, Fall 2016

Securities Lending Market

Rebate

Securities

Equity Market

Introduction

Mechanics of a Long/Short Market Neutral Fund, Shorting

Collateral

Broker

Hedge Fund

- Existing Inventory -

Interest

Collateral

- Customer Margin Accounts -

Money Market

Securities

Tracing the Flow of Assets and Cash The Hedge Fund borrows unowned securities from the Prime Broker who lends either from existing inventory, customer margin accounts, or from the securities lending market. The Hedge Fund executes a short sale of the borrowed securities into the equity market and receives cash. Cash collateral is posted by the Hedge Fund at the Brokerage for the securities borrowed. The Broker can deposit the collateral in a money market account which pays interest. The interest less a “short rebate� is paid to the Hedge Fund from the Broker. The original owner of the securities receives the short rebate.

JT & TA, Fall 2016

Introduction

Market Exposure

_ What does it mean for an investment to have Market Exposure _ How is Market Exposure Measured _ Can you predict future Market Exposure _ How might you eliminate Market Exposure in your Portfolio

_ What does it mean to be Market Neutral _ Asset managers frequently benchmark their performance to some ‘market’ what is the benchmark for a Market Neutral fund – what are the return expectations then

JT & TA, Fall 2016

Portfolio Math

Market Exposure - or “Betaâ€? is the slope of a regression line of periodic security returns against periodic market returns‌ it is thus a measure of the historic sensitivity of security returns to market returns and is widely used as a predictor of future sensitivity to market moves‌ systematic risk Market Neutral Funds - seek to largely eliminate market sensitivity in the portfolio‌ strategies that are market neutral are meant to capture return premiums that are separate and unique from the market return premium. These funds want to capture return regardless of market direction. Benchmark is Cash earning the risk free rate

Holding Period Return: đ??ťđ?‘ƒđ?‘…đ?‘– =

Annualizing Periodic Return:

đ?‘ƒđ?‘Ą − đ?‘ƒđ?‘Ąâˆ’1 + đ??ˇđ?‘–đ?‘Ł. đ?‘ƒđ?‘Ąâˆ’1

1 + đ?‘&#x;đ?‘Ž = (1 + đ?‘&#x;đ?‘ƒ )

Weight of Asset in Portfolio: �� =

HPR Portfolio of Assets: đ?‘›

đ?‘€đ?‘‰đ?‘– đ?‘› Ďƒđ?‘–=1 đ?‘€đ?‘‰đ?‘–

đ??ťđ?‘ƒđ?‘…đ?‘? = ŕˇ?

Beta of Asset to Mkt: ��,� =

1ྗ �

đ?‘–=1

đ?‘¤đ?‘– ∗ đ??ťđ?‘ƒđ?‘…đ?‘–

Introduction

Market Exposure

Portfolio Beta: đ?‘›

đ??śđ?‘œđ?‘Łđ?‘Žđ?‘&#x;đ?‘–,đ?‘š đ?‘‰đ?‘Žđ?‘&#x;đ?‘š

đ?›˝đ?‘? = ŕˇ?

đ?‘–=1

đ?‘¤đ?‘– ∗ đ?›˝đ?‘–

Market Neutral Performance β = -0.13 2008 = 6.3%

β = 1.16 2008 = (50.0%)

Mkt Neutral

Long Only

9.5

1.9

8.5

1.7

7.5

1.5

6.5

1.3

5.5

1.1

4.5 3.5

0.9

Mkt Downturns

Jan-13

Jan-14

Jan-11

Long Only

Jan-12

Jan-10

Jan-09

Jan-07

Jan-08

Jan-05

Mkt Downturns

Jan-06

Jan-03

Jan-04

Jan-01

Jan-02

Jan-99

Jan-00

Jan-97

Jan-98

Jan-13

Mkt Neutral Strategy

Jan-14

Jan-11

Jan-12

Jan-10

Jan-09

Jan-07

Jan-08

Jan-06

Jan-05

Jan-04

Jan-03

Jan-02

Jan-01

Jan-00

Jan-99

Jan-98

0.5

Jan-97

0.5

Jan-96

1.5

Jan-96

2.5

0.7

JT & TA, Fall 2016

Market Neutral Strategies are meant to provide absolute return independent of movements in the broader market. The emphasis is on providing non-correlated returns and can be marketed as an “asset class” that offers unique diversification benefits to a traditional multi-asset portfolio (Equities, Fixed Income, Real Estate for example). _ For the strategy to work Long Positions must outperform Short Positions in an up market and Short Positions must outperform (to the downside) Long Positions in a down market

Rising Market $1,000 Portfolio $120.00 $80.00

$40.00

Longs

Shorts

Introduction

Market Neutral Strategies

Net

Falling Market $1,000 Portfolio

_ The investing acumen (stock picking skills) of the manager is amplified and the margin for error can be small

$60.00

Long/Short Considerations _ Excess Return can be captured on both the Long and the Short portfolio – opportunity to benefit from mispricing's in both directions

Longs

_ With distinct Long/Short models possible to profit from disparate ‘style’ factors

Net

($160.00) ($220.00)

_ Short models that deliver positive return can be used to introduce leverage to the portfolio –leverage in this form has risk/return characteristics that are notably different from traditional leverage i.e. margin leverage _ Potential to directly hedge out defined risk factors (Market Neutral, Industry Neutral, Style Neutral)

Shorts

Flat Market $1,000 Portfolio $30.00 $20.00

Longs

Shorts ($10.00)

Net JT & TA, Fall 2016

Quantitative Investing – a method of investing that leverages data, technology, and math in an effort to better understand and exploit existing risk/return characteristics. Quantitative investors prioritize enhanced information processing across the entire portfolio construction and management process. Quantitative managers derive mathematical models from quantifiable data items and use these to generate buy/sell signals on assets. _ Grounded in Quantifiable Data – decisions driven by evidence in the data _ Mathematical and Statistical Relationships are Emphasized – “Predictive Analytics� _ Quants build Portfolios with Measurable Characteristics ≠Picking Stocks with Stories

What Drives Stock Returns ‌ Can Future Returns be Predicted (Valuation & Growth)

_ Any system that ranks stocks is quantitative

Primary Considerations in Portfolio Mgmt.

Alpha Generation (Stock Selection)

Risk Forecasting & Management

Optimizing the Risk Return Tradeoff

Implementation / Execution

Fundamental Quantitative Investing Models that describe and predict risk and return are used to inform the portfolio construction process.

đ??¸(đ?‘&#x;) = đ?›ź + đ?›˝1 đ?‘“1 + đ?›˝2 đ?‘“2 + đ?›˝3 đ?‘“3 + đ?œ€ Note: just like with qualitative methods there is more than one way to run quantitative investing. Loosely defined ‘quant’ is anything that leverages technology, data, and mathematical relationships to explicitly sort and pick investments. The technique that we teach here defines an expected return model based on factor exposures.

Quantitative Investing Overview

Quantitative Investing

JT & TA, Fall 2016

Style:

Inputs:

Qualitative “Fundamental”

_ Fundamental Data

_ Fundamental Data

_ Macro Economic Data

_ Macro Economic Data

_ Industry Analysis _ Management Interviews

_ Market Data (Price, Volume)

_ Conference Calls

_ Unconventional Data Feeds

_ Site Visits

_ Analyst Estimates

_ Analyst Estimates

_ News

_ News

Analysis:

Quantitative

Anything that is predictive & can be Quantified

_ Screening

_ Screening

_ Valuation Models (DCF, NAV, Residual Income, Real Options, DDM, …)

_ Explicit return drivers & exposures

_ Intuition and Subjective Opinion _ Competitive Position, Industry Opinion

Quantitative Investing Overview

Quantitative Vs. Qualitative Investing

_ Predictive Analytics & Statistical Models _ Alpha and Risk Predictions _ Formal Optimization

JT & TA, Fall 2016

Quantitative Investing

_ “Top Downâ€? economic view merged with deep understanding of individual companies in coverage universe ďƒ¨ What’s the coverage

_ Portfolio constructed to take exposure to defined factors that are priced ďƒ¨ Seeks defined exposure to predictive return drivers

_ Large number of analysts must correctly integrate Macro Economic, Sector Specific, and Single Company insights into portfolio Buy/Sell Decisions ďƒ¨ Emphasis on Depth

_ Small number of analysts must construct models which define factors and exposures _ Great emphasis on broad return drivers

_ Valuation model – valuation errors must be random and offsetting biases cannot enter the process ďƒ¨ What Drives a DCF Model

_ Errors are in defining the model parameters (model misspecification)

_ Unpopular positions can be difficult to ‘sell’ to Asset Mgmt. teamďƒ¨ Biases

_ Manager biases are mitigated by design

_ Potential for data mining

_ Stories have a powerful impact on perception

Qualitative Investing – DCF Models Year

0

1

2

3

4

5

Revenue

-

$150

$157.5

$165.4

$173.6

$182.3

COGS & OpEx

-

$105

$109.5

$114.2

$119.2

$124.4

EBITDA

-

$45

$48

$51.20

$54.40

$57.90

D&A

-

$8

$8

$8

$8

$8

EBIT

-

$37

$40

$43.2

$46.4

$49.9

Taxes

-

$14.8

$16

$17.2

$18.6

$19.9

NOPAT

-

$22.2

$24

$26.0

$27.8

$30

+ D&A

-

$8

$8

$8

$8

$8

- CapEx

$300

$10

$11

$12.1

$13.3

$14.6

- ∆WC

$25

$4

$4.5

$4.5

$4.5

$4.5

TV

($325)

$16.2

$16.5

$17.4

$18

$18.9

$385.75

FCF

Model Inputs _ Sales Grows at some fixed growth rate thru forecast period

Quantitative Investing Overview

Qualitative Investing

_ Most income stmt. Items are % of Sales _ Balance Sheet Items forecasted separately

�V =

đ??šđ??śđ??š5 1 + đ?‘” đ?‘Šđ??´đ??śđ??ś − đ?‘”

JT & TA, Fall 2016

Criterion

Qualitative

Quantitative

Advantages Objectivity

Low

High

Breadth

Low

High

Exposure to Behavioral Biases

High

Low

Replicability

Low

High

Cost

High

Low

Measurement & Control of Risk

Low

High

Disadvantages Ability to Use Qualitative Inputs

High

Low

Reliance on Historical Data

Low

High

Risk of Data Mining

Low

High

Quantitative Investing Overview

Strengths & Weaknesses

Source: Adapted from L. Chincarini and D. Kim, “Quantitative Equity Portfolio Management: An Active Approach to Portfolio Construction and Management� New York: McGraw-Hill, 2006. JT & TA, Fall 2016

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