Any investment strategy that is not ‘the market’ will experience periods of under performance. Sometimes quite extended like value investing in the late 90s. How an investor handles those periods of underperformance goes a long way to determining whether they have any chance of outperforming the averages over time. In today’s post I want to highlight the recent under performance of one the best performing quant strategy from What Works on Wall Street.
In my first post on quantitative investing I introduced the top quantitative investing strategies as presented in the book What Works on Wall Street by O’Shaughnessy. I focused on risk adjusted returns for the strategies but left out the top performing quant strategy by compound returns. The top performing quant strategy in the book from 1965 through 2009 is a value and momentum strategy that focuses on micro cap stocks. I’ve re-produced the chart form that post on the strategy results below.
For those looking to re-produce the strategy it is pretty straight forward. The strategy limits the universe of stocks to micro cap stocks. Then further limits the universe to those micro cap stocks in the top 30% by book to price. It then ranks the value micro cap stocks by 12 month return as long as the last 3 and 6 month return is above zero. The strategy then holds the top 50 stocks by equal weight. Hold for one year. Repeat. Over the period from 1965 to 2009 the strategy beat the SP500 by 12% a year! Impressive. Now, lets take a look at the performance of the strategy since 2009. Below is my implementation of the top micro cap strategy in Portfolio123. Over the full backtest period, to the beginning of 1999, the P123 implementation of the strategy performs similar to the documented strategy in the book.
Since the beginning of the current bull market the SP500 has outperformed the top micro cap strategy 1.9% per year. If you were implementing this strategy how would you react to this underperformance? Give up? Maybe. It would definitely be a challenge to stick with. What about previous bull markets? Well, we can look back at the last two, the late 90s and the 2001 to 2007 period. In the late 1990s the strategy underperformed the SP500, just like every other asset class, and in the 2001 to 2007 period the strategy vastly outperformed the SP500. Is there anything here to derive any meaning from? I don’t think so. Until about the second quarter of 2014 the strategy was outperforming the SP500. So, much of the underperformance is due to simply the choice of timeframe. It looks like just a normal period of underperformance. But something else could be going on as well. Something could have changed in the market to make the strategy less effective. I have a suspicion that the reliance on the book to price value metric has made the strategy less effective over time. But that’s a topic for another day. However, this brings up two important points in regards to quantitative investing.
In my opinion, as an individual practitioner of quant strategies, to increase chances of success in the long term a quant investor should consider two strategies. One, stick with tried and true factors and strategies that have been proven to work over the long term time and time again, study after study. Those three proven factors are company size, value, and momentum. Second, as a protection against human behavioral issues spread your quant investing across various strategies to make the certain periods of underperformance more tolerable. This by no means limits the opportunity size. There are thousands of ways to combine these factors and strategies into distinct approaches.
In short, an investor that takes on any approach that varies from the market averages will underperform during certain periods, often quite extended. By sticking with what has worked fundamentally over time and by spreading bets over various strategies a quant investor can increase their chances of success over the long term.
Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.