Systematic Equity Portfolio

Management
Sahand Haji Ali Ahmad
Alpha Signals
• These are the signals that predict the winners/losers ( have predictive
power over the returns and as such can predict the winners/losers)
• Could have predictive power over returns over different periods
• Some sort of daily data most likely has predictive power over very
short term windows, while a quarterly signal most likely helps explain
the quarterly returns
Well-known Signals
Accounting Factors (sourced from Compustat, Worldscope, Factset,…):
• Value ( Price/Earning, Book/Price,..)
• Growth( Revenue Growth rate, Earnings growth rate,…)
• Size
• Quality(Balance sheet quality, Debt to Equity,….)
• Profitability( Dividend yield, Earnings/Revenue,….)
• Dividend increase/decrease
• Liquidity
• MOAT (Morningstar-rated) equities
Technical Factors:
• Low-Volatility Anomaly
• Momentum ( Price momentum, Industry momentum,…)
• 20-day mean-reversion factor(Jegadeesh,…)
Example, Quality Factor
• A lot of divergence over the definition of a Quality factor
• Could even include Piotrski’s F-score including 9 factors
• Quality: Higher revenue and cash generation, more stable growth,
conservative yet effective capital structure, run by prudent managers
• 3 main categories:
• Profitability Generation: unique offering, Competitive position,…
• Earnings Quality: Earnings persistence, Accounting red flags, …
• Financial Robustness: effectiveness of capital structure, ability to
remain solvent, capacity to sustain growth
Quality
• Profitability Generation: Return on Equity, Return on Assets, Gross
Profit/Assets
• Earnings Quality: Accruals Ratio, change in Cash flow from
Operations& Net income
• Financial Robustness: Operating leverage, Financial leverage, Current
ratio(Current assets/Current liabilities)
• Selected: Return on Equity, Balance Sheet Accruals Ratio, Financial
Leverage
 Quality
• Return on Equity: 12-month income scaled by the company book value
• Persistence of Return on Equity

• Balance Sheet Accruals Ratio : more a company’s accounts are made up of

noncash items, the more error-prone their financial statements (Cash
Primacy)
• BSA: The ratio of the change in the net operating assets over the last 12
months and the average net operating assets over the same time period
• Perotti and Wagenhofer (2011) and Kozlov and Petajisto (2013) affirm that
the BSA ratio is the strongest predictor of stock returns.
Financial Leverage
• Companies which earnings would generally be less sensitive to the
volatility of the business cycle.
• Slight improvement in returns but much lower volatility(downside
protection for lower leverage)
• Similar to Low-Volatility anomaly, Higher quality stocks tend to
outperform in the long run, while they are less risky as well
• Z-scoring the above 3 factors and averaging them, we come up with
the aggregate Quality factor
• This quality index has a Sharpe ratio of 0.5 nearly twice the
benchmark. It outperforms more within the US market&Downturns.
Various Momentum Factors
• A momentum factor is constructed through the relationship between
equity and other relevant equities e.g through their analyst
connection, patent connection, attending same conferences, same
industry, ………………..
• Is built through weighing and adding exponential returns of the
connected equities
Other well-known signals
• Brokers and Analysts’ research reports and recommendations, Analysts’
upgrade/downgrade, Analysts’ revision
• News published on blogs and other well-known sources, WSJ, FT, Seeking
Alpha, Benzinga, Newswires,… using NLP
• Charts and Technical Analysis
• Social Media, Blogs, Web Searches, Website Traffic, Web Transactions,
Government and Regulators’ disclosures(SEC filings,…), Company
disclosures(10-k,8-k,…..), Earnings calls, Investor conferences, Investor
relations presentations, Press releases(public/private companies), using
NLP
• ESG factor
• Short Interest Data
• Insider buying/selling
• Options-implied signals
Signals based on Unstructured/Text data
• Using NLP for Text sentiment extraction:
1. Bag of words(count of positive words vs. negative words)
2. Joint Topic Modeling and Sentiment Detection using LDA
3. Training certain Deep Learning networks/Bayesian Networks to predict
the returns in the interval for assets after certain texts
4. Modeling the texts using word to vec, Supervised learning of the texts,
labeling the training texts with a sentiment score and using a Neural
Network to have the vectors as input and output the sentiment score
Lexalytics is a well-known company providing Text Analysis and Sentiment
extraction.
NLP on an Article in regards to an asset
• Named entity extraction: The algorithm has to first extract the identity of the speaker. Other examples of entities
include places/addresses, organizations, products/brands.
• Theme and category extraction: The algorithm establishes the topic being discussed. “Theme” is an industry term
for important phrases that are decided by the Machine Learning algorithm; examples would be “Fed hike”,
“Middle-Eastern crisis”, “iPhone7”, etc. “Category” refers to pre-defined buckets into which the sentiment score
could be aggregated; examples would be a stock ticker. The algorithm may also isolate new trending topics from
news articles.
• Intention and Sentiment: A sentiment score is assigned to the article using standard Natural Language Processing
(NLP) techniques. Often a simple “bag-of-words” approach or a rule-based assignment might be used to assess
sentiment.
• Relevance and Influence: A quantitative metric of relevance is assigned to the article based on its relation to the
traded assets. A quantitative metric of influence is assigned to the article/tweet, which measures the projection of
an opinion over social network connections. It could be based on popularity/following of author, links to other
prominent authors, etc.
Some existing work on applying NLP to Equity
markets(extracting sentiment, predicting
returns,..)
• Loughran/MacDonald work on using a Financial Dictionary for capturing
sentiment of 10-k,8-k and other EDGAR filings:
• “Using 10-K Text to Gauge Financial Constraints”
• “When is a Liability not a Liability?Textual Analysis,Dictionaries, and 10-Ks “
• Zhang : “Measuring the Information Content of Financial News”
• Ding: ”Knowledge-Driven Event Embedding for Stock Prediction”
• Ding: ”Deep Learning for Event-Driven stock prediction”
• Lee:” On the Importance of Text Analysis for Stock Price Prediction”
• Bag of words and part of speech works by Tetlock, Steven Young,…
Alternative Data Signals
• There are plenty of data sets being continuously uncovered. These data,
while sometimes sector-specific, can be useful in generating alpha (within
the category of the equities they cover).
• Analyst Opinions/Ratings : Closingbell, TIMgroup, TIPranks, estimize
• Digital Footprint(Apps(Download/Usage/…), Social(Facebook/Twitter/…),
Searches(Google/…), Websites/blogs/… ) : Alpha-DNA
• Options data are predictive(Spread/Implied Volatility/Volume/…): IVolatility
• Using AI/Deep Learning on price move patterns to make predictions :
Eidosearch, ….
Pattern Matching using AI/Machine Learning
• Eidosearch uses Pattern Matching in order to forecast the likelihood
for asset returns within a certain timeframe
• Many publications with significant results in this area:
• Chen: ”A LSTM-based method for stock returns prediction: A case
study of China stock market”
• I reconstructed the above-mentioned experiment with Russel1000
stocks and the results were equally impressive
• Akita:”Deep Learning for Stock Prediction Using Numerical and
Textual Information”
Alternative Data Signals
• App Usage:
• AppAnnie
• TalkingData
• QuestMobile
• Credit/Debit Card:
• Envestnet Yodlee
• 1010Data
• Arm Insight
• Second Measure
• Affinity Solutions
• First Data
• MasterCard Advisors
• UnionPay
Alternative Data Signals
• Email/Consumer Receipts:
• Edison
• Slice Intelligence
• SuperFly Insights
• Geo-location:
• Thasos
• Placed
• PlaceIQ
• Foursquare
• GroundTruth
• Advan
• Cuebiq
• Factual
Alternative Data Signals
• Satellite:
• Orbital Insight
• Descartes
• Rezatec
• BlackSky
• Satellite Imaging Corporation
• ICEYE
• Social/Sentiment:
• Dataminr
• VisibleAlpha
• RavenPack
• Estimize
• Prattle
• Enigma
• Sentifi
• Discern
Alternative Data Signals
• Survey:
• Prosper Insights & Analytics
• J Capital Research
• Civic Science
• Weather:
• Understory
• Aclima
• Public Data:
• Discern
• Enigma
• QL2
Alternative Data Signals
• Web Data:
• YipitData
• TH Data Capital
• Thinknum
• Savvr
• Vertical Knowledge
• Quad Analytix
• Prome
• Web Traffic:
• SimilarWeb
• Jumpshot
• comScore
Alternative Data by Sector
• Autos
• YipitData
• 7Park
• M Science
• Thinknum
• Quandl
• Manheim
• Statistical Survey
• RVIA
• China
• Jiguang
• Appannie
• Sandalwood
• M Science
• Pacific Epoch
• Quest Mobile
• TH Capital
• Talkingdata
• iResearch
• YipitData
Alternative Data by Sector
• Consumer
• NPD
• 1010Data
• YipitData
• Yodlee/Envestnet
• M Science
• 7Park
• Slice Intelligence
• Energy
• Orbital Insights
• Genscape
• Spaceknow
• Sky Watch
• Discern
• JWN Energy
• Spaceknow
Alternative Data by Sector
• Internet
• YipitData
• 1010Data
• Thinknum
• M Science
• 7Park
• Alexa
• AddThis
• Transportation
• Transcore
• Flexport
• American Trucking Association
• Geotab
• Travel
• Thasos
• YipitData
• JumpShot
• SimilarWeb
• STR
Importance of the data
• Data source with the greatest number of providers: Social/Sentiment

• Highest grossing data source: Credit/Debit Card

• Most utilized datasets: Web Data, Credit/Debit Card

• Most insightful datasets: Credit/Debit Card, Web Data

• Least insightful datasets: Geo-location, Satellite

Alternative Data Stack
Classification of the Signals
Deep Learning in predicting probability of market
correction
• we feed a large number of datasets into a Deep Learning model. The
model may first identify some simple features that negatively affect
the market such as a momentum breakdown, an increase in
volatility, a decline in liquidity.
Input, Model, Output
The Machine Learning Tools
Alpha Capture
• Capturing alpha from analysts’ reports/views/upgrades/downgrades
such as analyst members of TIM Group(The world’s largest
independent trade ideas network):
Criteria/Tests for Establishing Signals
• Fama-Macbeth regression for finding the factor loadings
• U-chart : Shows the expected performance of top1% of picks, followed by
the next 1%,…. Ending up with the bottom 1% at the same level (looks like
an inverse U , and visualizes whether the factor is good for long or short)
• Equity curve and its characteristics(Sharpe Ratio)
• Information Coefficient: Correlation of signal and returns(Pearson,
Spearman correlation)
• Information Ratio: Returns of active weights/Volatility of active weights
• Tracking Error: Volatility of the excess return of the portfolio over the
benchmark
Criteria/Tests for Establishing Signals
• Regression of return residuals over the factor value and significance
of the regression coefficient
• 63-day gamma(taking the average optimal portfolio for the last 63-
days and looking at its performance, which is more realistic as it will
have a lower turn-over and less execution cost)
• heat map for signal values moving from one class to another for the
next term(representative of signal’s potential turnover/costs)
• Decay profile for signal(first day return followed by second day,….
Until the day that expected daily return turns negative)
• Hit ratio of the signal: How many times the value for excess returns
predicted to be positive actually turned positive( The equity
outperformed the index)
Quantopian factor establishment
criteria/tests
• IC normal distribution QQ plots: should be a s-shaped curve
(representing normal distribution with fat tails)
To decide if the long/short of the first and last quintiles are good
• Calculate return of the portfolio of optimal factors within 21-days ,
63-days ( similar to decay profile) to see where it does the best
• The mean turnover:
• 62-day and 124-day period top and bottom quintile (proportion of
names new to quintile on the Y axis and X axis is the time)
• Categorize criteria for Return , Turnover, …. :
Portfolio Construction& Risk Control
• Portfolio construction aiming for maximizing expected return of the
portfolio subject to controls for certain factors such as
size/sector/volatility/ …
• Black-Litterman method
• A simple process where the weights vector is calculated based on the
equilibrium vector added to a vector of tilts based on the views,
where this process takes into account the confidence level in the
views also.
• Convex Optimization/Conic optimization:
The Old Vs New
• The old portfolio construction model based on Markowitz, was based
on a correlation matrix, which was very sensitive to the noise within
the returns of the single-name equities as these returns were used to
calculate the volatility matrix
• Proposed Solutions:
• Resampling of the efficient frontier, proposed by Michaud
• Goldfarb and Iyengar solved this(“Robust portfolio selection
problems”) by reformulating the constraints as second-order cone
constraints with a user-specified constraint threshold (Conic
Optimization)
Traditional Optimization Methods
• Markowitz Portfolio optimization problem including several second-degree
constraints
• Can be solved reliably and in a limited time using CLA(Critical Line
Algorithm)(unfortunately CLA is very sensitive to expected returns)
• Usually generic-purpose quadratic programming methods developed for solving
Conic/Convex optimization problems are used instead
• Hierarchical clustering is less sensitive to the Correlation matrix and performs
better out of sample
• Sensitivity to expected returns has led to risk-based asset allocation approaches
based only on covariance matrix, of which “risk parity” is a prominent example
• Still an issue as quadratic programming methods require the inversion of a
positive-definite covariance matrix (all eigenvalues must be positive). This
inversion is prone to large errors when the covariance matrix is numerically ill-
conditioned
• More Correlation, means more collinearity, means more ill-conditioned, means a
more error-prone portfolio construction for Markowitz !!!!
Portfolio Construction using machine learning
• Applying Hierarchical Risk Parity to Portfolio Construction Process (Marcos
Lopez De Prado)
• This method addresses 3 major concerns of quadratic optimizers:
Instability, Concentration, Underperformance
• Uses graph theory and machine learning techniques to build a diversified
portfolio based on the information contained in the covariance matrix
• unlike quadratic optimizers, HRP does not require the invertibility of the
covariance matrix
• Monte Carlo experiments show that HRP delivers lower out-of-sample
variance than CLA(Critical Line Algorithm), as well as Risk-Parity portfolio,
even though minimum-variance is CLA’s optimization objective
Why Hierarchical Clustering
• We need at least 1/2𝑁(𝑁+1) independent and identically distributed (IID)
observations in order to estimate a covariance matrix of size N that is not
singular. For example, estimating an invertible covariance matrix of size 50
requires at the very least 5 years of daily IID data. Correlation structures
change during such a long time.
• While covariance-based optimization is not hierarchical, the portfolio
construction method should be hierarchical as assets have different priority
• Hierarchical Portfolio Construction (HRP) method uses the information
contained in the covariance matrix without requiring its inversion or
positive-definitiveness using graph theory and machine learning to
construct the optimal portfolio
• Using both methods on a random example, shows that CLA concentrates
portfolio weights in a few stocks only, but Hierarchical clustering distributes
it among all the stocks, leading to much superior Monte-Carlo simulated
performance. Assuming no expected return for the assets, Hierarchical
Clustering portfolio shows much less realized volatility.
Hierarchical Clustering in a nutshell
1. (Tree Clustering)Based on asset returns, calculate correlations for pairs of
assets. Based on the correlation define a metric for distance of each pair of
assets.
2. Calculate the Euclidean distance of any two columns within the distance
matrix(each column represents distance of one asset from the others) (distance
of distance matrix)
3. Now we start growing clusters in a hierarchical fashion. Finding the closest two
, we form a cluster of them and we expand that cluster to include more
columns(aka assets)
4. (Quasi Diagonalization)reorganize rows and columns so that the largest values
lie along the diagonal (similar investments will be adjacent). We will have
multiple clusters of assets behaving similarly in each cluster.
5. (Bisection and Weight Allocation) Start the process of splitting each cluster in 2
and simultaneously allocating the appropriate weight to each asset
Transaction Cost Model
• The Old model (Kein and Madhaven):

• D(Nasdaq) is an indicator either 1 or 0

• Trade Size is the ratio of the order value to market Cap
• A number of models exist based on linear regression over factors such as
Order size, Trade Volume, Bid-Ask spread, Stock Volatility, Exchange Structure,…..
 Nomura Transaction Cost Model
Impact
14.0
Trade Period Post-Trade Period
10.5

7.0

3.5

0.0
0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2
Time
Transient Impact Temporary Impact Permanent Impact

( ) ( )
Total impact over the trade period

  2
METRIC =   S +   v   T +   v   T
• Where S is the average bid-ask spread,  is the volatility, v is the trade rate and T is the
trade duration
• Decomposes the cost into: Instantaneous Impact, Transient Impact, Permanent Impact
14
Machine Learning in Regime Shift Detection
• There are many ways to detect regime shift, such as Rodionov Regime
Switch,…
• One particularly popular way is to use Hidden Markov Models
together with Filtering of asset price time-series to create a Markov
Switching Regime Shift model
• Smoothening the time-series, and splitting it into 2-4 regimes ( bull,
bear, and possibly transition states)
Using Clustering for regime detection
Using Trend Filtering and Markov Switch
model
Regime-Switching multi-factor model for
asset returns
• Using a regime switching multi-factor model for macro asset prices,
and using BIC criterion to minimize, 4 regimes for macro assets are
detected.
• Equilibrium transition probabilities are calculated. These 4 states,
represent whether it is stable bull, stable bear, transition bull to bear
and transition bear to bull and can be very useful in deciding:
1) what should be the proportions of cash and equity
2) regarding equity portfolio, where should the weight be tilted
to(Value, Growth or momentum)
Some of Yin Luo stuff
Event Driven Trading
• Activist Investing(13D)
• CEO/CFO Turnover
• Dividend Policy Changes
• Complicated Firms
Activist Investing
Activist Investing stats
• Average monthly excess returns ranging from 88bps to 181bps after
adjusting for market, value, size, and price momentum.
Activist Investing
• One-month after the commencement of activism, a backtested portfolio of
targets yielded a market-adjusted return of 3.9%. After controlling for market,
size, value, and industry, the excess return was 3.0%.
• Twelve-months after the disclosure of activist involvement, a backtested portfolio
of targets produced an annualized excess return of 11.7% after controlling for
market, size, value, and momentum.
• Research finds no evidence that by utilizing Form 13F filings and taking positions
in pre-disclosed targets prior to the commencement of activism, increased excess
returns.
• Pre-activism, the targets tended to be (i) small-capitalization (ii) slow-growing (iii)
low payout (iv) financially healthy.
• Post-activism, the targets were characterized by having (i) higher financial
leverage (ii) lower cash holding (iii) higher payout (iv) no improvement to their
financial operations.
CEO Departure
CEO Turnover
Dividend Policy Change
Dividend Policy Change
Complicated Firms
• They lag the big changes in their representative industries
• Strategy: Identify companies where their underlying industries are
experiencing the strongest performance over the past month
• FASB Statement 14 requires that public companies provide information
regarding their reportable segments including the segments industry and
revenue
• Simple Firms - firms that derive greater than 80% of their total sales from
one industry segment
• Complicated Firms - firms where there largest industry segment accounts
for less than 80% of their total sales
• We weight simple industry returns proportionate to the company’s sales
in each industry in an attempt to identify where there have been
information shocks over the past month
Conglomerate Strategy Performance
Equities Classification and Statistical Arbitrage
• GICS
• AHL paper
• publications
Extract all I can from Talks(Quantopian,…)