CQA Investment Challenge

• Quant Methods in Long/Short Equity Investments

• Jon Tesseo- Signal Analytics

• Trent Ambler- Trepco Capital Partners

JT & TA, Fall 2016

Intro

du

ction

Learning Objectives and Format

This class provides an introduction to various portfolio management and investing techniques with particular emphasis on methods that contrast and enhance traditional long-only, qualitative approaches

_ Long/Short

_ Market Neutral

_ Quantitative Methods

_ Alpha Modeling

_ Risk Forecasting and Management

_ Attribution

_ Applied Equity Portfolio Management (we will be running a live, paper traded, portfolio)

_ Simulated Client Interactions

_ ‘Out of Sample’ Strategy Implementation and Testing

CQA Investment Challenge Deliverables

Client ‘Pitch’ –This will either be a mock RFP or Video Presentation Due Mid December

‘Quarterly’ Report –Summary of Performance, mock client communication Due Late Feb

To better facilitate the development of marketable, “real-world” finance skills we will be participating in a live investment challenge

_ Challenge Runs Oct. 31st – March 31st

_ Market Neutral/$ Neutral Equity Long – Short

_ $10mm AUM Paper Portfolio

_ Quantitatively Driven

JT & TA, Fall 2016

Intro

du

ction

Chicago Quantitative Alliance (CQA)

Participating Schools

The Chicago Quantitative Alliance (CQA) is “a professional investment organization comprised of leading quantitative investment practitioners. The CQA membership includes investment managers, plan sponsors, consultants, and other investment professionals. The primary goal of the CQA is to facilitate the interchange of ideas between quantitative professionals.”

_ Roughly 1,000 Member organization, Membership is intentionally limited and Highly Selective

_ Membership representation from many of the top quantitative investment firms and service providers (AQR, LSV, Quantitative Mgmt Associates, PanAgora, CapitalIQ, Axioma, Barra, Northfield, etc…)

_ The competition offers students from top U.S. and International Academic programs the opportunity to compete, winning teams are invited to CQA Conference and will have resumes circulated amongst CQA membership

Over 30 Participating Schools in 2015 Competition

Scoring

_ Weighted Sum _ 40% Sharpe Ratio_ 20% Absolute Return_ 40% Client Deliverables

Constraints

_ Market Neutral +/- 0.50_ Dollar Neutral +/- 5.0%_ Max Leverage 2:1_ Fully Invested (<5% Cash)_ 5% Maximum Position Size_ US Large Cap (Russell 1,000)

JT & TA, Fall 2016

Intro

du

ction

Mechanics of a Long/Short Market Neutral Fund, Shorting

Shorting Equities, Definition

Basic Definition: Short Selling involves the sale of a security that is not owned by the investor. Short sellers seek to profit from declining asset prices. Because short sellers do not own the security that is being sold they must Borrow the security before it can be shorted. There is an active securities lending market in the U.S. that facilitates this process – owners of securities agree to lend their holdings and receive collateral and a fee in return.

_ What do Short sellers do??

_ Are these actions Useful/Desirable??

JT & TA, Fall 2016

Intro

du

ction

Mechanics of a Long/Short Market Neutral Fund, Shorting

Shorting Equities, Definition

Short sellers endeavor to identify assets for which the market price is decidedly disconnected from fundamental value and profit from this disconnect through the execution of a short sale. The aggregate action of short sellers enhances the market price discovery mechanism and actually benefits the capitalistic system by facilitating the efficient flow of capital to productive assets.

Basic Definition: Short Selling involves the sale of a security that is not owned by the investor. Short sellers seek to profit from declining asset prices. Because short sellers do not own the security that is being sold they must Borrow the security before it can be shorted. There is an active securities lending market in the U.S. that facilitates this process – owners of securities agree to lend their holdings and receive collateral and a fee in return.

Shorting Equities, Challenges

_ Return Asymmetry, losses are theoretically unlimited while gains are capped at 100%

_ Upward Bias in the Market, short sellers are fighting equity risk premium that is positive in the long run

_ The psychological fortitude of the manager and the investors is important, Short Sellers are often lonely and are frequently vilified

_ Legal and Tax

_ Losing positions increase in Wt. (%)

_ Short Squeeze

Broken Business Model Fraud Overvaluation

JT & TA, Fall 2016

Intro

du

ction

Mechanics of a Long/Short Market Neutral Fund, Shorting

Hedge FundBroker

- Existing Inventory -

- Customer Margin Accounts -

Securities Lending Market

Equity Market

Money Market

Tracing the Flow of Assets and Cash

The Hedge Fund borrows unowned securities from the Prime Broker who lends either from existing inventory, customer margin accounts, or from the securities lending market. The Hedge Fund executes a short sale of the borrowed securities into the equity market and receives cash. Cash collateral is posted by the Hedge Fund at the Brokerage for the securities borrowed. The Broker can deposit the collateral in a money market account which pays interest. The interest less a “short rebate” is paid to the Hedge Fund from the Broker. The original owner of the securities receives the short rebate.

Sec

uri

ties

Securities

Collateral

Co

lla

tera

l

Interest

Reb

ate

JT & TA, Fall 2016

Intro

du

ction

Market Exposure

_ What does it mean for an investment to have Market Exposure

_ How is Market Exposure Measured

_ Can you predict future Market Exposure

_ How might you eliminate Market Exposure in your Portfolio

_ What does it mean to be Market Neutral

_ Asset managers frequently benchmark their performance to some ‘market’ what is the benchmark for a Market Neutral fund – what are the return expectations then

JT & TA, Fall 2016

Intro

du

ction

Market Neutral Performance

Market Exposure - or “Beta” is the slope of a regression line of periodic security returns against periodic market returns… it is thus a measure of the historic sensitivity of security returns to market returns and is widely used as a predictor of future sensitivity to market moves… systematic risk

Market Neutral Funds - seek to largely eliminate market sensitivity in the portfolio… strategies that are market neutral are meant to capture return premiums that are separate and unique from the market return premium. These funds want to capture return regardless of market direction. Benchmark is Cash earning the risk free rate

Portfolio Math

Holding Period Return:

𝐻𝑃𝑅𝑖 =𝑃𝑡 − 𝑃𝑡−1 + 𝐷𝑖𝑣.

𝑃𝑡−1

Annualizing Periodic Return:

1 + 𝑟𝑎 = (1 + 𝑟𝑃)ൗ1 𝑇

Market Exposure

Weight of Asset in Portfolio:

𝑤𝑖 =𝑀𝑉𝑖

σ𝑖=1𝑛 𝑀𝑉𝑖

HPR Portfolio of Assets:

𝐻𝑃𝑅𝑝 = 𝑖=1

𝑛

𝑤𝑖 ∗ 𝐻𝑃𝑅𝑖

Beta of Asset to Mkt:

𝛽𝑖,𝑚 =𝐶𝑜𝑣𝑎𝑟𝑖,𝑚𝑉𝑎𝑟𝑚

Portfolio Beta:

𝛽𝑝 =𝑖=1

𝑛

𝑤𝑖 ∗ 𝛽𝑖

0.5

0.7

0.9

1.1

1.3

1.5

1.7

1.9

Ja

n-9

6

Ja

n-9

7

Ja

n-9

8

Ja

n-9

9

Ja

n-0

0

Ja

n-0

1

Ja

n-0

2

Ja

n-0

3

Ja

n-0

4

Ja

n-0

5

Ja

n-0

6

Ja

n-0

7

Ja

n-0

8

Ja

n-0

9

Ja

n-1

0

Ja

n-1

1

Ja

n-1

2

Ja

n-1

3

Ja

n-1

4

Mkt Neutral

Mkt Downturns Mkt Neutral Strategy

0.5

1.5

2.5

3.5

4.5

5.5

6.5

7.5

8.5

9.5

Ja

n-9

6

Ja

n-9

7

Ja

n-9

8

Ja

n-9

9

Ja

n-0

0

Ja

n-0

1

Ja

n-0

2

Ja

n-0

3

Ja

n-0

4

Ja

n-0

5

Ja

n-0

6

Ja

n-0

7

Ja

n-0

8

Ja

n-0

9

Ja

n-1

0

Ja

n-1

1

Ja

n-1

2

Ja

n-1

3

Ja

n-1

4

Long Only

Mkt Downturns Long Only

β = -0.132008 = 6.3%

β = 1.162008 = (50.0%)

JT & TA, Fall 2016

Intro

du

ction

Market Neutral Strategies

_ Excess Return can be captured on both the Long and the Short portfolio – opportunity to benefit from mispricing's in both directions

_ Short models that deliver positive return can be used to introduce leverage to the portfolio –leverage in this form has risk/return characteristics that are notably different from traditional leverage i.e. margin leverage

_ Potential to directly hedge out defined risk factors (Market Neutral, Industry Neutral, Style Neutral)

_ With distinct Long/Short models possible to profit from disparate ‘style’ factors

Long/Short Considerations

Market Neutral Strategies are meant to provide absolute return independent of movements in the broader market. The emphasis is on providing non-correlated returns and can be marketed as an “asset class” that offers unique diversification benefits to a traditional multi-asset portfolio (Equities, Fixed Income, Real Estate for example).

_ For the strategy to work Long Positions must outperform Short Positions in an up market and Short Positions must outperform (to the downside) Long Positions in a down market

_ The investing acumen (stock picking skills) of the manager is amplified and the margin for error can be small

$120.00

$80.00

$40.00

Longs Shorts Net

Rising Market$1,000 Portfolio

($160.00)

($220.00)

$60.00

Longs Shorts Net

Falling Market$1,000 Portfolio

$20.00

($10.00)

$30.00

Longs Shorts Net

Flat Market$1,000 Portfolio

JT & TA, Fall 2016

Qu

an

titativ

e Inv

esting

Ov

erview

Quantitative Investing

Quantitative Investing – a method of investing that leverages data, technology, and math in an effort to better understand and exploit existing risk/return characteristics. Quantitative investors prioritize enhanced information processing across the entire portfolio construction and management process. Quantitative managers derive mathematical models from quantifiable data items and use these to generate buy/sell signals on assets.

_ Grounded in Quantifiable Data – decisions driven by evidence in the data

_ Mathematical and Statistical Relationships are Emphasized – “Predictive Analytics”

_ Quants build Portfolios with Measurable Characteristics ≠ Picking Stocks with Stories

_ Any system that ranks stocks is quantitative

Primary Considerations in Portfolio Mgmt. Fundamental Quantitative Investing

Alpha Generation(Stock Selection)

Risk Forecasting & Management

Optimizing the Risk Return Tradeoff

Implementation / Execution

What Drives Stock Returns … Can Future Returns be Predicted

(Valuation & Growth)

Models that describe and predict risk and return are used to inform the portfolio construction process.

𝐸(𝑟) = 𝛼 + 𝛽1𝑓1 + 𝛽2𝑓2 + 𝛽3𝑓3 + 𝜀

Note: just like with qualitative methods there is more than one way to run quantitative

investing. Loosely defined ‘quant’ is anything that leverages technology, data, and

mathematical relationships to explicitly sort and pick investments. The technique that we teach here defines an expected return model

based on factor exposures.

JT & TA, Fall 2016

Qu

an

titativ

e Inv

esting

Ov

erview

Quantitative Vs. Qualitative Investing

Style:Qualitative

“Fundamental”

Inputs:

_ Fundamental Data

_ Macro Economic Data

_ Industry Analysis

_ Management Interviews

_ Conference Calls

_ Site Visits

_ Analyst Estimates

_ News

Quantitative

_ Fundamental Data

_ Macro Economic Data

_ Market Data (Price, Volume)

_ Unconventional Data Feeds

_ Analyst Estimates

_ News

Anything that is predictive & can be Quantified

Analysis:

_ Screening

_ Valuation Models (DCF, NAV, Residual Income, Real Options, DDM, …)

_ Intuition and Subjective Opinion

_ Competitive Position, Industry Opinion

_ Screening

_ Explicit return drivers & exposures

_ Predictive Analytics & Statistical Models

_ Alpha and Risk Predictions

_ Formal Optimization

JT & TA, Fall 2016

Qu

an

titativ

e Inv

esting

Ov

erview

Qualitative Investing – DCF Models

_ “Top Down” economic view merged with deep understanding of individual companies in coverage universe What’s the coverage

_ Large number of analysts must correctly integrate Macro Economic, Sector Specific, and Single Company insights into portfolio Buy/Sell Decisions Emphasis on Depth

_ Valuation model – valuation errors must be random and offsetting biases cannot enter the process What Drives a DCF Model

_ Unpopular positions can be difficult to ‘sell’ to Asset Mgmt. team Biases

_ Stories have a powerful impact on perception

Qualitative Investing Quantitative Investing

_ Portfolio constructed to take exposure to defined factors that are priced Seeks defined exposure to predictive return drivers

_ Small number of analysts must construct models which define factors and exposures

_ Great emphasis on broad return drivers

_ Errors are in defining the model parameters (model misspecification)

_ Potential for data mining

_ Manager biases are mitigated by design

Year 0 1 2 3 4 5

Revenue - $150 $157.5 $165.4 $173.6 $182.3

COGS & OpEx - $105 $109.5 $114.2 $119.2 $124.4

EBITDA - $45 $48 $51.20 $54.40 $57.90

D&A - $8 $8 $8 $8 $8

EBIT - $37 $40 $43.2 $46.4 $49.9

Taxes - $14.8 $16 $17.2 $18.6 $19.9

NOPAT - $22.2 $24 $26.0 $27.8 $30

+ D&A - $8 $8 $8 $8 $8

- CapEx $300 $10 $11 $12.1 $13.3 $14.6

- ∆WC $25 $4 $4.5 $4.5 $4.5 $4.5 TV

FCF ($325) $16.2 $16.5 $17.4 $18 $18.9 $385.75

𝑇V =𝐹𝐶𝐹5 1 + 𝑔

𝑊𝐴𝐶𝐶 − 𝑔

Model Inputs

_ Sales Grows at some fixed growth rate thru forecast period

_ Most income stmt. Items are % of Sales

_ Balance Sheet Items forecasted separately

JT & TA, Fall 2016

Qu

an

titativ

e Inv

esting

Ov

erview

Strengths & Weaknesses

Criterion Qualitative Quantitative

Advantages

Objectivity Low High

Breadth Low High

Exposure to Behavioral Biases High Low

Replicability Low High

Cost High Low

Measurement & Control of Risk Low High

Disadvantages

Ability to Use Qualitative Inputs High Low

Reliance on Historical Data Low High

Risk of Data Mining Low High

Source: Adapted from L. Chincarini and D. Kim, “Quantitative Equity Portfolio Management: An Active Approach to Portfolio Construction and Management” New York: McGraw-Hill, 2006.