Exploiting the Low Volatility Anomaly
361 Global Long|Short Equity Fund
Harindra de Silva, PhD, CFA
Author: Ticker Magazine
Last Update: Mar 14, 10:55 AM EDT
|Investment returns are ultimately dictated both by how much you participate in the upside, and also how much you avoid the downside. Harin de Silva, portfolio manager of the 361 Global Long/Short Equity Fund, follows this principle by using the short portion of his portfolio as a hedge and relying on a systematic investment process that includes daily ranking and risk assessment of each stock.
ďOverall, our investment philosophy is based on being systematic, following written rules, and believing that low-volatility stocks will beat high-volatility stocks in the long run.Ē
We donít put the factors into groups for the analysis, but we group them for attribution. We use about 10 different valuation metrics and various growth measures, which show how fast the company is growing. We also use measures of liquidity in terms of the current volume and the volume relative to the stockís long run average, as well as relative to others in the industry. Another set of measures is related to financial risks and the earnings quality. It evaluates if earnings come from cash earnings or from accruals, if the company is highly profitable, whatís the asset turnover, etc. All of these measures are covered using a variety of different characteristics.
Q: What is your approach to the tactical weight allocation?
We have identified two systematic factors in terms of market rewards. First, the market tends to reward factors on a persistent basis. If a factor worked last month, it tends to work this month. And if a factor worked last year, it tends to work this year. So, there tends to be factor persistence on a three-year basis, because the last one to three years are very informative in terms of the factors, which are going to work going forward. Thatís what we mean by factor momentum. The second informative aspect is mean reversion in factors, and I think all factor returns come from investor behavior.
Q: How different is your strategy regarding the short portfolio? What additional work goes into it?
Shorting is not that different from going long, but there are two main differentiators. The first one is that stock returns are not normal. Stocks go up more than they go down. When we budget the risk for a stock, we aim to limit potential losses, so we would allocate a larger position to a low-beta stock. However, accounting for the fact that stocks go up more than they go down, we need to make sure that our short book is more diversified than the long book in terms of individual stock concentration.
The second and more important rule is related to human behavior, specifically to the difficulty admitting a mistake. When you are long and make a mistake on the stock, the mistake is self-corrected. In a systematic process like ours, where the risk controls would signal exceeding the risk in the stock, we would trim down the position. So, in the long book a mistake is not that critical, because it would correct itself. In the short book, however, when we are wrong and the position has become bigger than it should be, we have to bring it down in a way thatís appropriate to the risk of the stock.
Q: Would you elaborate on your optimization process?
The optimization process really allows us to build a portfolio that is long $100 and short $30, or to achieve $70 of exposure with beta of 0.5. The transaction cost is an important factor and is incorporated into the optimization. We focus on minimizing transaction costs and thatís a huge component of our investment focus. Our earlier allocation of resources used to be just portfolio management and research, while now it is portfolio management, trading and research. We believe that trading is really important as a way of saving costs and boosting performance.
Q: What is your portfolio construction process?
We spend considerable effort on forecasting the volatility of each stock. We look at the trailing volatility of a stock, the implied volatility from the options market, the ESG score and the news. We use all that data to adjust the forecast volatility of the stock, which in turn affects the relative position size
Our portfolio limits include a rule about maximum position size, so if a stock moves three times its standard deviation, it shouldnít cost us more than 50 basis points. Regardless of the volatility, though, we can never take more than 3% in a position. Thatís what determines individual position size.
We also have a set of rules around diversification in terms of the maximum exposure to any single industry, country, or region. These rules ensure that the portfolio has broad exposure to a wide variety of sectors and countries.
Q: How do you select stocks when the markets are sporadically volatile?
We look at three components. The long equity portfolio generates return in a slightly rising market, while our short book produces value in a falling market. The question is what to do when the market isnít going anywhere. Thatís where we have a stock selection process with a tilt to over 70 different factors based on their recent tendency. Currently, we place huge weight on quality and recent profitability, so if the market or high volatile stocks are going nowhere, these are the factors that will deliver returns for our clients over the next month.
Q: How do you define and manage risk?
We target beta of 0.5 and that means that if the market is down, we have 50% less downside volatility than the cap-weighted market index. We always maintain a consistent risk profile. We are explicitly not varying the risk profile of this portfolio; it is always 100 long, 30 short and always has a beta of 0.5.
Our goal is not to time the market, but to always have a short portfolio of 30% of high-beta stocks. We try to add value by shorting high-beta stocks that underperform in the long run. We get additional return by overweighting and underweighting the factors that investors are paying attention to, such as quality, value, leverage, etc.
The 2000Ė2002 period was an inspiration for this strategy, because it showed how weak the models were in terms of identifying the difficult investment climate. I thought that there had to be something better to rely on for portfolio protection, something that will always be in place. I believe that the basic principle for building any investment portfolio should be the underlying thinking of whatís going to be in place to help during a tough market environment.
Living through 2001 was really the inspiration that led me to the idea of low-volatility equity investing, which we started doing in 2004.
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