CONCENTRATION WITH CAVEAT
QAS IS AN EXPERT IN CONCENTRATED PORTFOLIO STRATEGIES
Executive Summary
Concentrated portfolios with multiple sources of alpha can improve risk-adjusted returns. In QAS models, these sources of alpha are controlled with our sophisticated quantitative algorithm based on advanced momentum factor methodology and optimal allocation techniques.
Except DIA and XLE, most major ETFs are based on large 100+ stocks indexes, representing largely-diversified market exposure and passive investment approach.
Our concentrated strategies are actively managed indexes, which constantly search their investment universe for optimal portfolio composition across different sectors.
This year we expect positively-biased market conditions, and therefore more concentration in investor’s portfolio is likely to deliver above-average returns. However, some sort of risk analysis (risk-control) is always a good idea.
“Nuts and Bolts” of Alpha
According to Bloomberg portfolio attribution analytics, there are two major sources of alpha: “selection” and “allocation”.
“Selection” is always the most complex task – you want to have an “all-star” portfolio with the highest upside potential to generate alpha. Typically, “stock-selection” is the only focus in a portfolio construction process. In major ETFs, their underlying indexes are based on a simple basket of stocks representing a specific market segment/exposure (market-cap, thematic, etc) without any dynamic changes (passive investment). Almost all major equity ETFs are based on large baskets of stocks (100+).
“Allocation” may appear as a less complicated item, but in reality – it can incorporate multiple segments that are equally important for alpha generation in “active” portfolio:
- Portfolio size (concentration vs. diversification)
- Rebalancing (position sizing)
- Risk management (exposure reduction or stock replacement)
There is research-based evidence that during “positively-biased” market conditions the concentrated portfolios tend to deliver improved risk-adjusted returns. We support this statement, but with one important condition – “effective risk control”. We used the same algorithm to select and allocate stocks within all major global benchmarks, and came to a conclusion that periodic portfolio risk evaluation and rebalancing provide necessary risk control and contribute to alpha generation.
Concentrated portfolios (relatively small number of holdings), are typically considered as an “active/hedge fund” solution, while passive investments are always created as large portfolio size structures. Concentrated portfolio is likely to be less correlated to a broad-based benchmark. Mathematically, any portfolio with 50+ stocks will have high correlation with the benchmark. At the same time, the optimal concentrated portfolio’s size is between 20-30 stocks (some hedge funds would hold 8-10 names), and it will tend to be much less correlated to the benchmark.
Historically, the US stock market has spent roughly 80% of the time within “positively-biased” market conditions. Therefore, mixing your portfolio with “concentrated themes” makes sense in order to achieve higher returns during longer periods of time. Otherwise, unless this is your specific investment objective, you tend to be over-diversified within “low risk/ low return” performance segment. Mathematically, you will produce highly correlated to the benchmark average returns.
QAS APPROACH
We specialize in long-only concentrated portfolio strategies. We believe that our risk methodology (QAS Risk Zone Classification) has an effective mechanism to generate consistent positive excess return in a concentrated portfolio over the long period of time.
Stock Selection and Portfolio Size
Stock selection in our work is always accompanied by Risk Zone analysis, including both “absolute” (vs. other stocks in the universe) and “relative” (vs. benchmark) momentum analyses. In some thematic strategies we try to narrow down our investment universe to reflect specific advantages vs. benchmark. This also contributes to “selection” source of alpha.
Depending on the size of the investment universe, our concentrated portfolio size will vary from 20 to 40.
Rebalancing (position sizing)
Based on our methodology design, the optimal rebalancing period is once a month. We prefer equal-weight rebalancing. Effectively, the portfolio periodically takes profit from leaders and finances laggers, attributing to overall alpha generation (as part of source of alpha – “allocation”).
Risk management
Stocks with a high QAS Risk Zone profile (deteriorating momentum factor) will be replaced with stocks with low QAS Risk Zone profiles. The algorithm will always search for the best possible portfolio composition (positive momentum) in all market conditions. This becomes more difficult during broad-based market declines as less stocks are eligible for inclusion.
Therefore, we took into consideration all possible (optimal) sources of alpha, including:
- Sophisticated Stock-Selection (narrow investment universe, risk evaluation)
- Frequent (monthly) rebalancing and position sizing
- Risk management via dynamic stock replacement
Examples
- QAS US and Global New Economy Stock Selection Strategies
Let’s see how our concentrated portfolio strategies performed during the most recent market recovery in October 2023 – February 2024 (five months period). QAS Global New Economy consists of 25 stocks, while QAS US New Economy consists of 20 stocks.
As an example, the unique stock-selection mechanism helped to identify early reversals in cybersecurity and semiconductor sectors, which helped getting ahead of the S&P 500 index:
2. QAS India Stock Selection Strategy
QAS India Stock Selection Strategy (local currency) generated roughly 4x return vs. NIFTY 50 benchmark during 2023-2024YTD period. This concentrated portfolio consists of 20 stocks, and the same algorithm for “selection” and “allocation” was applied.
In conclusion, we can list the following prerequisites for effective long-only concentration strategy:
- Long-term positively-biased market
- Specific theme/ exposure that has attractive qualities
- Effective risk management
Generally speaking, our approach can be described as “proceed with caution”. This could be a key “low correlation” component in a larger/ diversified (multi-strategy/exposure) portfolio.
For more information, free trials and partnership program please visit:
