Do quant-based value models work out-of-sample?

If you want to have faith that quant-based value strategies still work, check out LSV Asset Management. This Chicago-based firm is run by Josef Lakonishok, a Ph.D. who had specialized in behavioral finance. In 1994, he realized that the key to investing success was quantitative value investing. He now has $112 billion under management, and his small cap and microcap value funds, all of which are quant-based, have been steadily beating the market, even over the last few years. The record is impressive: their US Small-Cap Value, US Microcap Value, Non-US Small-Cap Value, Emerging Markets Small-Cap Value, Japan Small-Cap Value, Europe Small-Cap Value, and Canada Small-Cap Value are ALL beating their benchmarks. Which is pretty remarkable for out-of-sample performance.

Here is their investment philosophy and practice, from About LSV - LSV Asset Management

Also check out the bios of their investment team here: Investment Team - LSV Asset Management. One of them (Han Qu) does nothing but backtesting and simulations.

The methods that Portfolio123 enable and encourage actually work. Portfolio123 was founded with a very similar philosophy to Lakonishak’s: that judgmental biases and behavioral weaknesses often influence investment decisions for the worse, and that quant-based fundamentals investing based on a deep understanding of accounting measures together with rigorous and proper backtesting and simulations can lead an investor to systematically beat the market while minimizing risk.

Looking at the performance, all their US strategies except micro (large, mid, small) have under-performed their benchmarks in the past 3 to 5 years… same for Japan and Canada large cap strategies. Europe strategies haven’t been around long enough.

I was interested in what, exactly, their “quantitative methods” were.

I found this presentation by the Partner and Director or Research. Also a Professor of Finance. I have attached 2 slide images from his talk.

Looks like he is constructing a portfolio along the “efficient frontier” of modern portfolio theory in the second slide.

Obviously this just determines the weight of each position once they use their methods to determine the “return each stock is expected to earn” and each stock’s “variances and covariances.”

I cannot find much else other than their use of behavioral finance.

-Jim



Philip,

You are right to point out that LSV has been underperformaning their benchmarks in the past 3-5 years.

Symmetric.io is a hedge fund tracking firm used by Bloomberg and they calculated the returns of hedge funds by comparing the performance of equities in the funds with that of a sector exchange-traded fund. The firm grades the stock-picking ability of nearly 1,000 hedge funds in its database with their proprietary indicator, Stockalpha. Below are the comparisons of LSV Asset Management vs Tiger Global/Lone Pine Capital.

Regards
James




James,

That’s pretty cool information on hedge fund alpha. Also, Jim mentioned that LSV uses MPT based on variance of stock pricing and covariance between stock prices. If nobody was doing this it would be a great approach. However because the strategy of diversifying through historical correlation is commonly used in portfolio construction it has the unintended consequence of leading to higher security correlation. Perhaps that and indexing have led to higher correlation in stocks over the last few years. It is probably like all commonly used investment strategies that get broadly used that it is losing both its alpha generating ability and actually accumulating a big fat risk tail. When everybody is constructing MPT portfolios based on historical anti-correlation that collapses now everyone is exposed to the same risk which multiplies that risk to an avalanche scenario. By no means am I a finance PhD, but the herding but I do know that herding in markets is dangerous. MPT also concerns me because in its purest form you are selecting companies not on fundamentals but on historical price action. Correlations can quickly change despite history leaving a portfolio fully exposed.

Just some of my musing…

Jeff

Thanks James - do you know who the top stockalpha funds are?

RT,

Here are are a few small hedge funds which has high scores. You can replicate their portfolios with their quarterly 13F disclosures.

Regards
James




It’s a mistake to judge performance based on the last three years. It’s simply far too short a sample, and everybody knows that 2019 was deeply aberrant. I’m talking about long-term success here.

Yuval,

We are all talking about alpha capture these days.

If a hedge fund manager underperformed the index consistently for the last 3 years (ie. -ve alpha), you will notice a lot of fund redepmtions. For instance, AQR did poorly in the last 2 years and their AUM dropped by more than 30% due to redemptions.

Regards
James

Agreed, the psychological cost of underperforming the market for 3 -5 years outweighs the benefit of maybe marginally outperforming in the long-term. I would just invest in the market instead of LSV.

I like quant based strategies and want LSV to do well. I will keep looking but I have missed the excellent 10-year results: see image.

I welcome any proof that what they are doing is working. No problem with being shown to be embarrassingly wrong on this.

Honestly, it would make me happy.

Edit: They do better on micro-caps but not Large-, Mid-, or small-caps at 10 years. A little happy now.

-Jim


Maybe I’m looking at this wrong, but if you go to this page https://www.lsvasset.com/us-small-cap/ and click on each of the small-cap and microcap strategies (there are eight of them), all of them outperform their respective benchmarks over the lifetime of the fund, over the last ten years, and, with one exception, over the last five years. Their large-cap and mid-cap strategies have a more mixed record.

Yes. Thank you Yuval. It does do better here.

I truly want this fund to do well. This is good!

Technically, .01% better on the large-caps too when I get out my reading glasses (again good).

-Jim

This makes sense based on backtesting. It’s easier to identify mispriced stocks in smaller caps. If you do a large cap only backtest it’s hard to achieve much outperformance unless you excessively curve fit. At least that’s what I’ve observed. Maybe a few percent outperformance is all you can realistically achieve in large cap land.

Jeff

The fact that they only modestly outperform in small and micro cap stocks is humbling…

There is the effect that as you manage more money it is harder to outperform. Liquidity is key to being able to trade a strategy. If you have less money to invest the number of shares you purchase is a smaller portion of that available daily volume. As you accumulate more funds to invest, micro and eventually small caps become more difficult to get in and out of. The nature of micro and small caps is that you have to execute shorter holding periods because fundamentals for small companies are more volatile. Yuval has a great article on this from the past few weeks. So as you accumulate more money to invest you become unable to make big percentage investments in micro and small caps which don’t have enough liquidity. If you do decide to try to buy those stocks you will need to accumulate and resell those shares over several days as to not cause the price to significantly move against you. That being said security mispricing becomes less possible and prices more stable as you grow on market cap. People think Warren Buffet has lost his edge. That’s not true. The problem is that he can’t really buy the small or medium caps he used to buy without either acquiring them outright or significantly moving the price. So Buffet mostly buys large caps these days. Even if he buys small caps they don’t account for much of his portfolio. I think we have an advantage over institutions and even Buffet for this reason if we can properly utilize available information and apply it via sound valuation models.

Jeff

This might be an additional reason. They also have to own too many stocks.
Verdad which has a quant process has limited their assets to combat the issue you talk about Jeff.

https://blogs.cfainstitute.org/investor/2019/10/03/the-active-manager-paradox-high-conviction-overweight-positions/

That’s a good article. Do you think the other issue might be that they have to try to pace the market every year? That is why they include risk reduction assets. Over the long run they would outperform with more volatility if they only bought those high conviction stocks. Investors might get scared away by that volatility and a couple bad years. It’s something to keep in mind when we design strategies. Aggressive, but sound strategies may underperform for periods of time but yield higher returns in the long run.

Jeff

There has been a good deal of research comparing the performance of “high-conviction” stocks to “low-conviction” stocks in the portfolios of active managers. I haven’t read much of it. But this particular study suffers from a pretty glaring flaw. When the researchers chose which securities were overweight and underweight in the mutual funds, they did not consider the weight of each security when it was initially added to the mutual fund. Instead they simply compared the current weight of the security to its weight in the benchmark. The overweight portfolio thus was more likely to include stocks that had appreciated in price since they were bought, and the underweight portfolio was more likely to include stocks that had fallen in value. In addition, because the weights were compared to the weights in the benchmark, and since most of the benchmarks are cap-weighted, if two stocks had the same weight in the mutual fund, the smaller stock would be placed in the overweight portfolio and the larger stock would be placed in the underweight portfolio. The relative performance of these portfolios could thus be completely explained by the momentum and size factors, which were not taken into account when publishing the results.

Normally I like the articles in Enterprising Investor, but this one didn’t convince me at all.

I know of one asset manager who has based a quant fund on the high-conviction picks of other asset managers. And he’s a very smart man too. I suspect, though, that he’s following the wrong herd.

Yuval,

Those are good points that I didn’t glean from the reading. Do you think most hedge funds aren’t really doing that great of a job at picking out performers after all? With that in mind it seems as if a better indication is accumulation/distribution rather than weighting as the change is more indicative than the level.

Jeff