Where we left off

In GAA, I pursued a sector-specific long-short strategy:

Targeted market-neutrality
Industry-specific long and short baskets were identified on a
monthly basis through a screen of targeted factors
Results were mixed
Factors provided attractive In-Sample results but were less
compelling Out-of-Sample
While less volatile over-all and market neutral, the strategy did
not outperform the benchmark on an absolute basis
 Next Steps#1,#2,#3
Model Improvement:
1) Fix the Factors: Test additional screening
criteria to develop a better model
2) Optimize: First-cut model employed
subjective scoring for multivariate screens.
Optimization provides a more robust
approach to weighting factors
3)Dynamic Weighting: Explore the benefits of
time-varying factor weights to incorporate
information from macroeconomic events
 Next Steps#4
Tailor the Implementation:
4) Make the strategy deployable at a small scale:
Not an asset manager by trade, so adjust application
so I can use this knowledge for personal fun and profit
Limit trading: Valuation Screen as a fundamental overlay to
reduce number of securities traded
Less Rebalancing: Extend rebalancing period and assess
impact to returns
 #1 Fix the Factors
Original:
Short Interest - total short positions currently open for a given equity as
a percentage of total shares
Fundamental Debt Factor - incorporates information about cost of debt
and leverage ratio
Change in Consensus Percent change in EPS estimate
Revised:
Prospective Earnings Yield provides a primary fundamental
measure and is expectational in nature
3 month revision rate indicates direction of most recent information
observe by market analysts
36 mo MA 60 mo MA technical factor to indicate momentum and
trends

Outcome: Better Screen, Better Results

 3 month Revision
Portfolios - equal weighted
-1- -2- -3- -4- -5-

Alpha
145.7 145.7 140.7 156.1 157.1
6.00 113.9 122.5 126.9 119.5 123.4
90.2 91.6 92.8 96.8 86.9
119.7 124.7 118.2 114.5 115.5
5.00 111.6 116.1 123.3 125.9 132.1
122.3 123.7 124.7 128.8 126.5
116.7 119.0 117.8 109.4 120.8
4.00 120.5 120.9 123.5 114.0 119.9
100.8 100.4 101.3 93.2 100.5
108.9 113.7 111.5 110.7 109.0
3.00
132.9 128.3 126.5 136.3 127.8
116.0 115.4 122.8 119.9 118.1
142.5 152.8 147.3 155.9 154.8
2.00
111.3 106.6 110.4 112.2 112.2
113.0 83.1 110.3 110.0 99.0
104.6 90.8 95.7 106.6 112.4
1.00
103.8 108.9 96.2 109.2 94.9
69.9 75.9 80.2 81.6 93.0
- 144.0 143.2 133.1 140.7 146.0
1 2 3 4 5 109.4 113.2 107.2 105.3 115.2

Average relative performance

3.8 3.1 2.7 2.7 2.7
 36 mo Moving Avg 60 mo Moving Avg
Portfolios - equal weighted
-1- -2- -3- -4- -5-

Alpha 145.7 145.7 140.7 156.1 157.1

8.00
113.9 122.5 126.9 119.5 123.4
90.2 91.6 92.8 96.8 86.9
119.7 124.7 118.2 114.5 115.5

6.00
111.6 116.1 123.3 125.9 132.1
122.3 123.7 124.7 128.8 126.5
116.7 119.0 117.8 109.4 120.8
4.00
120.5 120.9 123.5 114.0 119.9
100.8 100.4 101.3 93.2 100.5
108.9 113.7 111.5 110.7 109.0

2.00
132.9 128.3 126.5 136.3 127.8
116.0 115.4 122.8 119.9 118.1
142.5 152.8 147.3 155.9 154.8
111.3 106.6 110.4 112.2 112.2
-
1 2 3 4 5 113.0 83.1 110.3 110.0 99.0
104.6 90.8 95.7 106.6 112.4

(2.00)
103.8 108.9 96.2 109.2 94.9
69.9 75.9 80.2 81.6 93.0
144.0 143.2 133.1 140.7 146.0
109.4 113.2 107.2 105.3 115.2
(4.00)

Average relative performance

3.8 3.1 2.7 2.7 2.7
 Earnings Yield
Portfolios - equal weighted
-1- -2- -3- -4- -5-
Alpha
135.0 148.3 143.7 171.5 167.9
14.00
111.3 107.3 96.4 108.2 111.5
79.5 82.2 89.6 95.0 83.3
12.00
109.4 110.8 119.0 122.0 123.4
102.8 113.3 116.2 111.2 109.4
10.00
105.3 113.8 100.7 123.1 117.2
123.8 118.6 125.3 140.8 144.5
8.00
123.6 137.2 137.3 143.0 164.3
89.3 91.5 99.0 99.8 107.3
6.00
103.1 101.0 113.0 113.1 116.5
120.9 131.0 133.5 153.4 172.3
4.00
121.1 119.0 128.9 128.9 140.0
151.7 150.8 166.4 171.5 159.6
2.00
115.5 91.0 93.4 85.0 80.0
93.6 102.7 100.1 88.4 106.3
-
80.8 109.8 115.0 130.9 164.9
1 2 3 4 5
109.7 107.7 115.3 109.6 124.5
(2.00)
77.4 78.8 84.1 87.3 83.7
164.3 144.4 147.2 155.3 167.8
(4.00)
108.2 103.5 109.0 108.3 115.2

Average relative performance

4.1 3.9 2.9 2.1 1.9
 #2 Optimize
Matrix for Correlation

Use optimization (as Factor 1

3m Rev
Factor 2
3mv-5mv
Factor 3
EY

opposed to subjective Factor 1

Factor 2
Factor 3
1.00
0.07
(0.22)
0.07
1.00
(0.10)
(0.22)
(0.10)
1.00

scoring to build multi- Matrix for Covariance

Factor 1 Factor 2 Factor 3
variant screen 3m Rev
2.48%
3mv-5mv
3.74%
EY
3.73%
2.48% 0.06% 0.01% -0.02%

Target different 3.74%

3.73%
0.01%
-0.02%
0.14%
-0.01%
-0.01%
0.14%

Matrix for (X i )(X j )(Cor ij )( s i )( s j ) --which is the same as (X i )(X j )(Cov ij )

acceptable level of Factor 1
3m Rev
Factor 2
3mv-5mv
Factor 3
EY
Weights (Xn) -75% 71% 105%
volatility (sensitivity
analysis)
 #2 Optimized Heat Map Portfolios - equal weighted
-1- -2- -3- -4- -5-

Alpha 1985 152.2 147.9 153.4 143.0 145.9

1986 116.0 128.7 125.1 109.7 117.1
7.00 1987 87.8 89.6 94.4 92.4 90.8
1988 125.5 122.8 116.9 115.3 106.2
6.00 1989 119.8 116.8 119.6 119.5 123.3
1990 138.6 116.7 121.3 130.0 121.2
1991 124.9 113.9 122.6 114.1 113.2
5.00
1992 126.1 125.9 112.3 119.1 115.8
1993 104.5 105.8 93.3 93.6 88.7
4.00 1994 124.3 111.5 113.1 107.4 107.6
1995 138.3 135.3 137.4 127.2 131.0

3.00
1996 117.9 119.5 120.8 113.1 117.5
1997 146.6 147.6 151.4 151.4 146.8
1998 117.9 105.9 107.9 112.7 91.8
2.00
1999 120.9 101.7 100.6 99.1 95.5
2000 97.5 98.6 122.5 105.4 106.4
1.00

Hold -out / Out of Sample

-
1 2 3 4 5 2001 111.8 112.6 100.0 101.8 86.5
2002 76.2 75.0 88.5 84.6 80.9
2003 147.7 143.0 144.8 134.2 137.6
2004 110.3 109.7 108.3 113.4 110.4

Outcome: Better Screen, Better Results

#2 Optimize

Excel Printouts: Comparison on frontier

 #3 Dynamic Factors
Strategy Returns in Periods with Interacting with Yield Curve Slope
Flattening Yield Curves
Changes in Weighting when 10 yr
Nov 88 Jun 90
yield less 6 mo yield is less than 1%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 New Optimization delivers different

weightings

Nov 97 Feb 01 Minor change in performance

1st Episode = 0.045%/month
advantage
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 2nd Episode = (0.017%)/month
Interacted for Dynamic weighting Not Compelling as Executed
Static Weighting
 #4 Scale Down
Implementation is Difficult at small scale:
With scoring screen limiting to 250 securities, still long 50 and
short 50
Monthly rebalancing prohibitive
Solution:
Automate a fundament sort of the long-short basket to further
reduce holdings
Explore rebalance at 6 / 12 month intervals
 #4 Valuation Screen
Goal: apply an objective criteria to narrow the total population
of the identified long and short baskets
Process:
Attain consensus forecasts for stocks in long and short basket
Apply mechanical valuation, building and explicit valuation forecast for each
security in in the 1st and 5th fractile
Assume consensus performance and a 15 yr linear ramp-down to
performance at their cost of capital
Compare mechanical valuation to market price select top 10 undervalued
longs and top 10 overvalued shorts
Results:
Painful to apply (manual data entry, requires a more elegant execution)
Potential for information gaps (i.e. lack of forecast, not all securities
covered)
Sacrifices returns (on average), spikes volatility

Disclaimer: more rigorous back-testing necessary

#4 Valuation Screen

Excel Printouts: Structure of inputs and sort

on valuation information
 #4 Rebalance Period
Goal: assess trade-off in expected return from longer
rebalancing 7.00

6.00

5.00

Return SD Sharpe 4.00

3.00

1 month: 8.5% .11 .78

2.00

1.00

-
1 2 3 4 5

7.00

6.00

5.00

4.00

3.00

2.00

6 month: 7.0% .08 .85

1.00

(1.00) 1 2 3 4 5

9.00
8.00
7.00
6.00
5.00
4.00
3.00

12 month: 8.7% .15 .60 2.00

1.00
-
1 2 3 4 5

Conclusion: Small sacrifice for longer rebalance

 Conclusions
Optimization beats Subjective
Dynamic Factoring must be refined
Long-Short can be scaled down, but risk
obviously increases
A little bit of knowledge can be dangerous