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An Alternative Way to Develop Low Risk Equities Strategies

by Patrick Oberhaensli, on Jul 30, 2019 2:14:00 PM

In our alternative way to develop Low Risk strategies, we won’t consider individual stocks portfolios.  Instead, we will focus on the market as a whole, exploiting a completely different anomaly but still in a quantitative (and not qualitative) approach. This leads to an advanced way of investing which considers short exposure as well as no exposure at all (simply cash). Increased flexibility within the exposures allows to better exploit the opportunities arising from the anomaly (which here has two sides).

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Market Observations

The anomaly we will focus on in this article, is related to multi-risk observations that lead to the development of advanced (risk-based) strategies. What does it involve? Well, it starts with long lasting market observations, not only being present in the midst of the market action but also participating in it. These observations are then transformed into quantitative rules that finally deliver market signals: A rules-based method with systematic application. Therefore, the basis isn’t of statistical nature as it would be for trend-following and comparatively these two methods deliver very different results. However, in both approaches qualitative evaluations are typically not done unless for risk control purposes should there be a (very) unusual sharp and rapid drawdown requiring human intervention.  There are also clear quantitative triggers particularly in this situation.


Applying Short Positions

Another common aspect in the two techniques is the use of short positions. There is potential value in going short for a risky asset especially when it exhibits negative skewness and a left hand-side fat tail as it is the case for equities among others. But again, the “behavior” of risk-based and trend-following will differ here as well. For risk-based, there doesn’t need to be a downtrend in order to be short-exposed, it actually requires a risky situation.

It is the model development that leads to the specifications of the mentioned rules. In other words, the human talent is expressed at an early stage of the investment process. Of course, the models will need to be updated as the anomaly changes and not because there has been a drop in the performance (that would actually be a bad sign).


Very Diversifying Combinations

In order to achieve an exceptionally low long-term maximum drawdown, a diversifying combination of models is typically necessary. This is especially true in the context of a risk-based approach in which the maximum drawdowns are particularly reduced versus passive long-only investing: It happens already at the level of the individual models.  As a consequence of such combinations, the out-of-market positioning appears – if it wasn’t already considered before.

When it comes to the presentation of the results, we propose here the concrete case of Diversified US Large Cap Equities:

Between the 1st of January 2000 to 3rd of July 2019, following characteristics for a long-short-out of the market and unleveraged risk-based Diversified US Large Cap Equities investment can be exhibited. The figures take account of specific costs and comparisons are made versus passive long-only.

Risk-Based Diversified US Large Cap Equities

We can see that the maximum drawdown over the whole period, calculated on daily returns and not just monthly ones ,which is more conservative, is particularly small as it is less than 1/3rd of the long-only passive market.

At the same time, the excess return is larger than 775 basis points which even is bigger than the average return of a long-only passive investment. Only the volatility is at the same level as the long-only.  However, this is less relevant given that the distribution of the risk-based portfolio isn’t Normal. In terms of beta, with 0.06 we are very far away from the classic low beta approach in which the beta is typically more than 10 times bigger!

Looking at our profile classification for the Low Risk Equities: the discussed strategy comes into profile 3: “Low beta equity portfolio (well below 1 or even negative beta) with above-market return target”.

The same approach of multi-model combination can also be applied to US Large Cap Growth Equities.  This is of course not adapted for the classic low beta anomaly as these stocks typically exhibit high(er) betas, resulting in another key advantage of the risk-based technology: that is increased versatility.


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Conclusion

We may conclude by saying that Low Risk Equities can be based on a different anomaly other than the well-known low beta or volatile ones. Because that new anomaly appears at the level of large whole markets, liquid futures allow an easy and cost-efficient implementation of the short exposure as well. The possibility to go short permits to benefit from a "double" alpha which further optimizes the risk-adjusted performance.


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Topic:Asset AllocationInvestment StrategyDiversificationAnalysis and StrategyLow Risk EquitiesESG
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