Wednesday, July 31, 2013

Remain calm, stick with your discipline

Earlier in the week, I spoke to an institutional portfolio manager running a quantitative process who was having some difficulty with his performance. The markets have been volatile and stocks have been hit by cross-currents, not only by macro related events, but also by stock specific news this Earnings Season.

My advice to him consisted of, in essence, to remain calm and stay with your investment discipline. Academics Van Gelderen and Huij recently wrote a paper entitled Academic knowledge dissemination in the mutual fund industry: Can mutual funds successfully adopt factor investing strategies?
In this study, we investigate if investors that have adopted investment strategies based on asset pricing anomalies documented in the academic literature (i.e., the low-beta, small cap, value, momentum, short-term reversal, and long-term reversal factors) consistently earn positive abnormal returns. For this purpose we evaluate the performance of a large sample of U.S. equity mutual funds over the period 1990 to 2010. We find evidence supporting the value added of investors adopting factor investing strategies: low-beta, small cap, and value funds earn significant excess returns. We also find that these excess returns are sustainable and have not disappeared after the public dissemination of the anomalies when more asset managers have started to adopt factor investing strategies. We propose some criteria that might be helpful to determine the successful application of academic insights in the context of investment strategies. Our findings have significant implications for the role of academic research and knowledge management in the investment management industry.
The authors concluded that quantitative factor investing like low-beta, small-cap and value continues to work, even after all these years. In another but unrelated post about factor performance and failure, Dorsey Wright highlighted a paper about how model performance isn't always consistent and poor performance may be related to impatience [emphasis added]:
There is another reason to believe that these strategies offer the prospect of future return premia for patient, long-term investors. These premia are very volatile and can disappear or go negative for many years. The chart on the following page highlights the percentage of 36-month rolling periods where the factor-based portfolios – high quality, momentum, small cap, small cap value and value – underperformed the broad market. 
To many investors, three years of under-performance is almost an eternity. Yet, these factor portfolios underperformed the broad market anywhere from almost 15% to over 50% of the 36-month periods from 1982 to 2012. If one were to include the higher transaction costs of the factor-based portfolios due to their higher turnover, the incidence of underperformance would be more frequent. One of the reasons that these premia will likely persist is that many investors are simply not patient enough to stay invested to earn them.
They concluded:
[W]hether you choose to try to harvest returns from relative strength or from one of the other factors, patience is an underrated component of actually receiving those returns. The market can be a discouraging place, but in order to reap good factor performance you have to stay with it during the inevitable periods of factor failure.
My advice to any underperforming portfolio manager is:
  1. Know your time horizon;
  2. Know the strengths and weaknesses of your investment approach;
  3. If you think that there is something wrong with your investment process, diagnose and fix it, otherwise stick to your guns;
  4. Manage risk properly and pay particular attention to and properly apply Grinold's Fundamental Law of Active Management; and
  5. Don't panic and stick with your discipline.
Bad performance is no fun at all, but if you are convinced that you can produce alpha over an appropriate time horizon, stick with your investment discipline.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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