Each professional investment strategy has some sort of investment objective. These objectives are simple and logical: investors want certain levels of positive returns and to exceed specific benchmarks such as the “free rate of return” or broad-based equity indexes.
The ability of a portfolio manager to deliver “excess return” is often limited to his skills and experience with certain markets and methods of market analysis. We can clearly see that the majority of investment funds have a very specific focus targeting certain market segments (examples: large cap, small cap, technology, value, growth, low volatility etc).
It is logical to assume that a portfolio consisting of multiple funds can add more independent sources of alpha, because we are supposedly adding a new skill level and method of analysis. The same logic is applied when we try to improve a core portfolio by adding more risky instruments expecting higher return.
It is important to have a clear understanding of each independent source of alpha and to have the ability to measure their contribution to the overall performance.
Counting sources of alpha
In reality, most investors are only exposed to simple strategies with two sources of alpha - securities selection and position sizing (allocation), which are limited by the portfolio manager’s area of interest or investment product specialization.
The QAS research toolbox allows for additional independent sources of alpha that can co-exist in the well-oiled portfolio structure.
For example, we created the QAS US Equity Multi-Regime Index to address the following issues raised by sophisticated investors:
- In 2016, the Small Cap segment delivered significantly higher returns vs. Large Cap. At the same time, financial advisors tend to avoid the Small Cap segment due to higher volatility of this segment and difficulties with reliable tactical allocation. It’s good to have the ability to boost investment returns when Small Cap stocks outperform Large Cap stocks.
- Financial advisors ignore Leveraged ETFs for many reasons (mostly risk concerns). These products are largely used by day-traders for short-term strategies. Investors feel they miss an opportunity for above-average returns during expanded low-volatility periods.
- It’s good to have the ability to differentiate between light corrections and severe market declines. A good strategy should have several layers of protection.
In summary, investors would like to take advantage of the risky instruments during positive market periods and protect their investment during negative market periods.
To address these issues we have implemented a “five regime” tactical allocation scheme based on the ETF instruments:
Regime 1 [ Most Aggressive, Leverage ] We add a 2x Leveraged ETF exposure to core.
Regimes 2, 3 [ Normal Positive] We rotate between Large Cap / Small Cap exposure.
Regime 4 [ Neutral, Min. Protection ] We reduce equity exposure lightly.
Regime 5 [ Most Defensive, Safety ] We reduce equity exposure significantly, add safety instruments.
As a result, we address all issues raised by a sophisticated investor, and created a product (strategy) that incorporates up to 5 independent sources of alpha:
- Core portfolio
- Small Cap
- Light Protection
- Heavy Protection
The QAS US Equity Multi-Regime Index represents a unique tactical allocation strategy that has expanded the traditional set of 1-2 sources of alpha up to 5. It includes the logic from several stand-alone strategies we have developed before, and various score-based quantitative techniques based on QAS research capabilities.
According to historical back-test, the index delivered +12.8% CAGR vs. 8.2% S&P 500 TR for 2006-2017YTD period, reduced 2008 drawdown, and outperformed significantly in 2008, 2009, 2010, 2012, 2013 and 2016.
The index is maintained in QAS production and Bloomberg with the start date of 01/01/2016.
The excess return level has been consistently above 300 bps, and currently it is at 600 bps level and rising for the period of 2016-2017YTD.
For more information please visit www.qas-service.com. Institutional investors only.
Quantitative Analysis Service, Inc.