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Why Most Quantitative Investing And Trading Systems Fail

By Baijnath Ramraika, CFA “Invert, Always Invert.” – Carl Gustav Jacob Jacobi, German Mathematician “Hundreds of studies have shown that wherever we have sufficient information to build a model, it will perform better than most people.” – Daniel Kahneman (as you read this statement, don’t forget to consider the implication of the word “sufficient”) “Roger Federer plays tennis using Wilson racquets. I use Wilson racquets. Does that make me Roger Federer?” – Paraphrasing a friend of ours. In an interesting post, the fund manager Dominique Dassault talked about a time when he was fascinated with quantitative black box trading systems. As he was talking to a leading quantitative portfolio manager about quantitative systems, the portfolio manager said something that surprised Dassault: While quantitative algorithms may work for a while, even for a long while, eventually, they all just completely blow up. When asked about the reasons for the blow up, here is what the he had to say: Because despite what we all want to believe about our own intellectual uniqueness, at its core, we are all doing the same thing. And when that occurs a lot of trades get too crowded… and when we all want to liquidate (these similar trades) at the same time… that’s when it gets very ugly. Dominique went on to offer a good summary of what quantitative managers are doing, including low-enforced backtest volatility, high leverage and increased concentration of risk. All have a very logical rationale. However, at the core of this problem is a much more basic issue: logical fallacy. Defining quality – The quantitative way Most, if not all, quantitative systems are designed by selecting factors that were present in successful investments/trades over the selected backtest period. Typically, a system developer will pick up a host of factors and run simulations in order to identify which factors were associated with better investment returns. To further expound upon this process, let’s consider the case of quality as an investment factor. This has received a lot of attention from academics as well as developers of quantitative investment strategies. It is the latest fad in the jungle of investment factors. Most quantitative strategies that promise to utilize quality as the dominant selection factor employ returns on capital or some variation of it. This is driven by the finding that companies that generated higher returns on capital have been associated with higher subsequent investment returns. Of course, as quantitative managers try to step over each other in an effort to showcase the superiority of their system, most of them gravitate towards significantly more complex systems, introducing a multitude of factors in their models. The idea that a high-quality business generates higher returns on capital passes the muster of commonsense as well. Let’s say that the average return on capital of all businesses is 10%. What this means is that when you invest $100,000 in a business, on average, you will expect to earn US$10,000 from your investment. But what if the business that you invested your $100,000 was earning you $15,000 instead? Most quantitative systems, as they define quality currently, will likely conclude that we have a high-quality business on our hands. The fallacy of the converse Clearly, for a business to be considered superior, it needs to generate returns on capital that are greater than the average business. While this statement, if correct, establishes that all high-quality businesses are associated with high returns on capital, it does not follow that all businesses that earn high returns on capital are high-quality businesses. But that’s exactly what most quantitative systems are likely to conclude. As high returns on capital are likely to be present in every high-quality business, the quantitative system will likely conclude that every business that earns excess returns on capital is a high-quality business. This argument is not very different from saying that because I play using Wilson racquets, I am Roger Federer! This kind of an argument construction falls in the trap of fallacy of the converse, also known as affirming the consequent . Consider the following argument form: If dog, four legs (another way of saying that dogs have four legs). Four legs (I found something with four legs). Therefore, dog (this thing is a dog). Obviously, this is an invalid argument. Not everything that has four legs is a dog. Similarly, not every company that is earning returns on capital in excess of cost of capital is a high quality business. High returns on capital – A necessary but not sufficient condition As Daniel Kahneman said, wherever we have “sufficient” information to build a model, it will perform better than most people. We posit a key question here: While ability to earn higher returns on capital is a necessary condition for the presence of a high-quality business, is it a sufficient condition? Before you jump to a conclusion, we thought it instructive to share with you the business experience of Baijnath’s father. Back in the 1970s, in a small town of northern India, the elder Mr. Ramraika started a business selling clothes. His industry showed up in his business performance, and he was quickly able to earn returns on capital that were well above the cost of capital. The necessary condition of high returns on capital was met. But did he have a high-quality business? Over the next few years, the business landscape changed. Attracted by the success of businessmen like the elder Ramraika, many more entrepreneurs entered the business, using either their own capital or borrowings. The same town which had about five such businesses in the ’70s now houses more than 100 such businesses. So while the target customer base increased by a factor of three, the number of competitors increased more than 20-fold! Not surprisingly, the end result of this process was sub-par returns for everyone involved. What happened? Why did the number of competitors mushroom? The answer lies in the absence of barriers to entry. The barriers to entry, if there were any, were surmountable. It was possible for other entrepreneurs to enter the business. As additional capital flowed in, returns on capital were driven down. Clearly, it was not a high-quality business. It was a business that was enjoying a temporary competitive advantage that emanated from a demand-supply mismatch. A situation that had an over-rectification as capital flowed to reap the perceived excess rewards. Avoiding the fallacy of the converse: Invert, always invert The key issue here is that most quant systems seek out factors that were associated with trades/investments that generated superior investment returns. Such a process ignores Jacobi’s insight, “Invert, Always Invert.” It is as important, if not more so, to understand those cases that shared the same characteristics but did not work well. For example, if one were to study the fate of the elder Ramraika’s business, it would be abundantly clear that the lack of entry barriers drove returns on capital down. This insight leads to the conclusion that excess returns on capital is not a “sufficient” condition. For the business to be able to sustain the excess returns, barriers to entry need to be present, and they need to be strong. Conclusion Be careful before jumping to yet another conclusion. Much like the error with accepting returns on capital as the sufficient condition, if you conclude that barriers to entry is the sufficient condition, you will be falling prey to the same fallacy. If barriers to entry are present, but they do not lead to higher returns on capital, a business is still not high-quality. Judging the presence or absence of barriers to entry is best handled by qualitative, human judgement, while judging the superiority of returns on capital is best handled by the machine. The underlying cause of eventual failure of most quantitative investing and trading strategies has to do with how the factors are identified. Those that apply Jacobi’s suggestion and focus on sufficiency of conditions in their model definitions will carry much lower risk of system failure. This article first appeared on Advisor Perspectives .

PIMCO High Income Fund: Is The Pain Over?

Summary PHK’s premium has fallen from over 50% to around 30%. That’s a big drop and well below the CEF’s 3-year average premium. So is the pain over and now the time to buy back in? The PIMCO High Income Fund (NYSE: PHK ) is a contentious closed-end fund, or CEF, that has a long history of trading at an impressive premium to its net asset value, or NAV. Right up front, I’m not a big fan of any CEF trading above its NAV, particularly at such an extreme premium. However, after such a large drop, some investors may be wondering if the hurt is over and whether now might be a good time to buy in. A little background To understand why a closed-end fund trades at a price different than its net asset value, you have to understand how CEFs differ from their mutual fund cousins. Mutual fund sponsors stand ready to buy and sell shares at the close of every trading day at NAV. Therefore, there’s a premade liquid market at NAV. Closed-end funds, meanwhile, sell a set number of shares to the public. Those shares then trade based on supply and demand on the open market. If investors like a CEF for whatever reason, they will demand a higher price to get them to sell. And if investors don’t like a CEF for some reason, they will take lower prices to get out. Thus, CEFs trade above and below their NAV. The NAV is still what the shares are worth – it is their intrinsic value, if you will. But it isn’t always what they will trade for. Using a simple example, if investors are fond of biotechnology a biotech-focused CEF might find itself trading at a 10% premium to NAV. The reason is investor sentiment; essentially investors are saying they expect good things from the CEF in the future. The important take away is that investor sentiment is the driving factor – not the actual value of the CEF’s shares. People really like PHK Closed-end funds normally trade around their NAV or at a discount. It’s unusual to see a CEF with a long history of trading well above NAV. PHK, then, is an exception to the norm. It’s long traded at a premium, and notably, at an extreme premium to its NAV. For example, its three-year average premium is nearly 50%. Its five-year average is just over 50%. People really like PHK. I’ve posited that the reason for this premium was partially because Bill Gross took over managing the fund in 2009, the year in which the premium started to widen. Since he’s no longer there, others have noted the fund’s steady distribution even through a difficult market period – notably the 2007 to 2009 recession. In the end, it’s probably a combination of the two. But whatever the reason, the CEF has a long history of trading well above its NAV. Which is why some argue that the selloff from an over 50% premium to the more recent 30% premium is a buying opportunity. This is a normal investment approach in the closed-end fund space, buying when a CEF is notably below its average premium/discount. The idea being that investor sentiment likely went too far in one direction and will eventually swing back toward the historical level. On the one hand, this makes sense for PHK. The average premium is close to 50% in recent history, so at a 30% premium, it’s fallen pretty far from the norm. In fact, this isn’t the first time there’s been such a drop. In the back half of 2012, PHK went from a roughly 75% premium down to a 25% premium before recovering to a 40% premium and eventually to the 50% and 60% levels seen earlier this year. I’d say, for aggressive investors who like to trade premiums and discounts, this is a CEF you should be looking at. Still too expensive But if you are a conservative investor, you should still avoid PHK. Why? We know with almost no doubt what PHK is worth; that’s the point of net asset value. That’s the value of PHK, no more and no less. If you buy PHK for a 30% premium, you are paying 30% more than its portfolio is worth on a per share basis. One of the reasons why playing premiums and discounts works is because you know the value of the asset you are buying – its NAV. So when a CEF is trading well below its NAV, there’s a clear catalyst for the discount to narrow. As investors realize the disconnect between price and value, they’ll correct it. PHK, however, is trading below its historical premium . Which means that anyone buying now is betting that investor sentiment will improve so that the premium gets wider. That’s akin to momentum investing in which you buy an expensive stock hoping that you can eventually sell it to someone at an even more expensive price – with little regard to its intrinsic value. There’s nothing wrong with this when it works, and it does work for some people. But it can also go horribly wrong when investors have changed their minds. Think back to the carnage in the dotcom bust, when investors realized that they didn’t like Internet companies as much as they thought they did. The companies didn’t change, investor psychology did. So, if you are a conservative investor, why bother buying something you know is overpriced? There are so many investment options in the market that taking such risks just isn’t worth it. And that’s true even taking into consideration PHK’s 15% yield. I’d rather take a yield half that and sleep well knowing that I don’t have to rely on fickle investors to buy my shares at a higher price. Or, better, yet, I’d rather buy something trading below its NAV and below its average discount, and wait for the market to realize the price disparity. With the NAV being a magnet to draw investors in to an undervalued investment opportunity. So, if you are an aggressive CEF investor looking to play discounts and premiums, PHK is definitely worth a look. Just go in knowing the game you are playing. I’d still suggest caution, but the fall from the average at PHK fits the bill for the trade. For conservative investors, don’t get sucked in by a big yield or the fall in the premium. PHK is still expensive even after its premium has fallen some 20 percentage points, and the yield just isn’t worth paying a still high 30% premium. You’ll be better off investing elsewhere. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

A Look At The Energy Sector Impact On Dividend ETFs

Summary While every index is slightly different, one theme that you often see repeated throughout the high dividend arena is an emphasis on big energy names. As a result of the energy sector woes over the last 12 months, I thought it prudent to look at the overall impact of these stocks on total return. One example of a fund with an outsized allocation to energy stocks is the iShares Core High Dividend ETF. One of the most popular strategies at our firm is the Strategic Income Portfolio, which focuses on a multi-asset approach to generate consistent income and overall low volatility. In order to accomplish those goals, we are continually scanning the ETF landscape to evaluate suitable equity income funds that meet our investment criteria. These ETFs typically consist of high-quality stocks with above-average dividend streams and low internal expenses. While every index is slightly different, one theme that you often see repeated throughout the high dividend arena is an emphasis on big energy names. Exxon Mobil (NYSE: XOM ) and/or Chevron Corp. (NYSE: CVX ) are commonly in the top 10 holdings of these diversified dividend portfolios. According to dividend.com, XOM has a current dividend yield of 3.74% while CVX yields 5.00%. As a result of the energy sector woes over the last 12 months, I thought it prudent to look at the overall impact of these stocks on total return. In addition, it should be noted that ETFs with a fundamental or dividend weighting methodology may be increasing their energy exposure in the future to adjust for the higher yields these companies are now paying. One example of a fund with an outsized allocation to energy stocks is the iShares Core High Dividend ETF (NYSEARCA: HDV ). This ETF is based on the Morningstar Dividend Yield Focus Index, which selects 75 stocks based on their high dividend yields and financial history. HDV currently has $4.3 billion in total assets, a 30-day SEC yield of 3.90%, and an expense ratio of 0.12%. The top holding in HDV is XOM, which makes up 8.3% of the total portfolio. Energy stocks as a whole are the second largest sector in HDV with a total weight of 18.45%. Obviously, this is going to result in these energy companies making a big impact on total return and overall yield. On a year-to-date basis, HDV is down 1.50% while the broad-based SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) has gained 2.63%. This path of divergence really kicked into high gear over the last two months as the energy sector rolled over once again. While this overweight exposure has certainly been a drag on HDV, it hasn’t been a catastrophic event because of the counterbalancing effect of consumer staples and healthcare stocks. Other well-known dividend ETFs with a relatively healthy dose of energy exposure include: Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) ~ 11.90% energy Schwab U.S. Dividend Equity ETF (NYSEARCA: SCHD ) ~ 11.40% energy WisdomTree Equity Income ETF (NYSEARCA: DHS ) ~ 13.55% energy First Trust Morningstar Dividend Leaders Index ETF (NYSEARCA: FDL ) ~ 10.62% energy Investors who believe the carnage in the oil & gas space is due for a bounce may be more inclined to choose a dividend ETF with a higher weighting in this sector. Conversely, those that are less enthusiastic about the prospects for an imminent recovery may choose to underweight or avoid these funds altogether. I continue to own VYM as a core equity income holding in my Strategic Income Portfolio. Despite its flat performance so far this year, the diversified basket of over 430 dividend-paying stocks offer attractive value characteristics and a dependable 30-day SEC yield of 3.26%. In addition, the ultra-low 0.10% expense ratio keeps the overall portfolio fees to a minimum. The Bottom Line One of the most important exercises that individual investors can do is analyze the index construction of their ETF holdings. Take note of any sectors that your funds are overweight or underweight in order to gauge how they will react under different circumstances. That way you are prepared in the event that a significant divergence occurs and can make adjustments as necessary. In addition, it’s important to reevaluate the portfolio on a quarterly or semi-annual basis. These funds undergo regular rebalancing and may shift their exposure based on the mandate of the index provider. Disclosure: I am/we are long VYM. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: David Fabian, FMD Capital Management, and/or clients may hold positions in the ETFs and mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell, or hold securities.