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U.S. Quantitative Research
Nomura Securities International, Inc.U.S. Quantitative Research
Nomura Global Quantitative Equity Conference in London
Natural SelectionNatural Selection
Joseph Mezrich Please read the analyst certifications and important di l 27 29 l
17 May 2011
Nomura Securities International Inc, New York.Global Quantitative Research
disclosures on pp. 27-29. gl
U.S. Quantitative Research
Bacteria vs Dinosaurs
• Bacteria are, and always have been, the dominant forms of life on Earth.
• The fossil record of life begins with bacteria.
• Bacteria exist in overwhelming number and unparalleled variety.
• Bacteria inhabit effectively every place suitable for the existence of life.y y p
• Should quantitative investors emulate dinosaurs or bacteria?
2Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Do quants have ‘dinosaur’ risk?
How do bacteria diversify? Local adaptation to changing environments
Local adaptation = optimizing to a specific (local) objective function
3Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Outline Examples of structural change in popular factors –Examples of structural change in popular factors
sources of ‘dinosaur’ risk
Selection for different objectives – examples of adaptive investing
• Factor momentum and the success of quants – dinosaurs?
• Low factor volatility and high factor momentum
Risk parity for strategy combination• Risk parity for strategy combination
• Alpha repair – yet another adaptive strategy
4Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
“Regime change” for factors: Example 1 …Regime change for factors: Example 1 …
350
400
250
300
350
etur
n (%
)
Up-to-down Revisions
100
150
200
lati
ve fa
ctor
re
0
50
100
Cum
u
EBITDA/EV
N t Sh l ti thl t t t d i i d EBITDA/EV i R ll 1000 i F t t
-50
1979
1980
1982
1983
1985
1986
1988
1989
1991
1992
1994
1995
1997
1998
2000
2001
2003
2004
2006
2007
2009
2010
5Joseph Mezrich, 212.667.9316, [email protected]
Notes: Shows cumulative monthly returns to up-to-down revisions and EBITDA/EV in Russell 1000 universe. Factor returns are based on equal-weighted decile spread returns. Analysis ranges from January 1979 through April 2011. Transaction costs are not considered.Source: Nomura Securities International Inc. , Russell. I/B/E/S, Compustat, IDC.
U.S. Quantitative Research
… Example 2: Accruals still work for high-estimate-dispersion stocks
250
300High estimate dispersion stocksMid estimate dispersion stocksLow estimate dispersion stocks
… Example 2: Accruals still work for high estimate dispersion stocks
200
n to
Acc
rual
(%
)
p
Recession
100
150
umul
ativ
e re
turn
Regulation FD
0
50
8 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 0
Cu
Regulation FD
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Note: Universe is Russell 3000. Shows cumulative monthly returns to accruals (equally weighted quintile spread) in each of threegroups categorized by level of dispersion of analyst estimates for current-year earnings (deflated by the absolute value of meanestimate). Accruals are based on Sloan’s (1996) definition using three-month change in trailing four-quarter average in financial statements not using 12-month change in annual financial statements as Sloan originally used Period of analysis is from January
6Joseph Mezrich, 212.667.9316, [email protected]
statements, not using 12-month change in annual financial statements as Sloan originally used. Period of analysis is from January 1989 through March 2011. Transaction costs are not considered.Source: Nomura Securities International Inc., Compustat, IDC, Russell, I/B/E/S, NBER.
U.S. Quantitative Research
… Example 3: B/P has moved from low beta to no betaa p e 3 / as o ed o o beta to o beta
0 5
0.6B/P- Estimate dispersion
0.2
0.3
0.4
0.5
elat
ion
p
-0.2
-0.1
0
0.1
Rank
Cor
r
-0.4
-0.3
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
B/P-Beta
Note: Shows cross-sectional rank correlations between B/P and beta, and between B/P and estimate dispersion in the Russell 1000 universe. Period of analysis is from July 1984 through February 2011. Source: Nomura Securities International Inc., Russell, Compustat, IDC, I/B/E/S.
7Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Factor momentum – selection based on return persistence
8Joseph Mezrich, 212.667.9316, [email protected]
Notes: Shows monthly factors (factors are non-sector neutral) selected using the highest factor momentum strategy (60-month) in the Russell 1000. At each point of time, there are three selected factors. The factor labels are sorted according to frequency of selection, with highest frequency at the bottom. Period of analysis are from January 1984 to March 2011.Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell and IDC
U.S. Quantitative Research
Quant core funds beat fundamental core funds in Q1 2011
Quant vs. Fundamental
Q f d
6
8
%)
+4 bp in YTDQuant core funds
2
4
mul
ativ
e al
pha
(
+151 bp in YTD
0
2
Cu
Dec 2010Fundamental core funds
Notes: Shows cumulative average alpha (relative return to the benchmark) in large-cap core funds based on quantitativemethodologies (dark blue line) and large-cap core funds based on fundamental methodologies (light blue line). Currently, 16
-2
2003 2004 2005 2006 2007 2008 2009 2010 2011
9Joseph Mezrich, 212.667.9316, [email protected]
g ( ) g p g ( g ) yquant core funds and 48 fundamental core funds are in each fund universe. Transaction costs are not considered. Period ofanalysis is from January 2003 through April 2011.Source: Nomura Securities International Inc., Bloomberg, Russell, S&P.
U.S. Quantitative Research
Factor momentum fuels quant core funds
35
408 Cu
Quant fund alpha and factor momentum
Quant core funds
20
25
30
4
6
mulative return ot
core
fund
s (%
)
Aug 2007
0
5
10
15
2
4
of 5yr factor momve
alp
ha o
f qua
n
Five year factor momentum
gQuant meltdown
-15
-10
-5
0
-2
0
mentum
(%)
Cum
ulat
i
Aug 2010Five-year factor momentum
Notes: Shows cumulative average alpha (relative return to the benchmark) of quant core funds (dark blue line) together withcumulative return of five-year factor momentum strategy, where the best five factors (long/short baskets) are owned as long-short positions among our 52 factors based on five-year factor performances in the Russell 1000 universe. Currently, 16 quantcore funds are in the fund universe. Transaction costs are not considered. Period of analysis is from January 2003 through
2003 2004 2005 2006 2007 2008 2009 2010 2011
10Joseph Mezrich, 212.667.9316, [email protected]
core funds are in the fund universe. Transaction costs are not considered. Period of analysis is from January 2003 throughMarch 2011.Source: Nomura Securities International Inc., Bloomberg, Compustat, I/B/E/S, Russell, S&P and IDC.
U.S. Quantitative Research
Factor momentum historically fuels quant core funds
140
160y
(%)
Quant fund alpha and factor momentum
Five-year factor momentum (best 5 factors from 52 factors)
5
10
100
120
140 Cumulative alph
men
tum
str
ateg
y (best 5 factors from 52 factors)
Five-year factor momentum (best 10 factors from 52 factors)
Quant core funds
-5
0
40
60
80
ha of Quant Core
urn
of f
acto
r m
om Aug 2007Quant meltdown
-15
-10
-20
0
20
funds (%)
Cum
ulat
ive
retu
Notes: Shows cumulative average excess return of quant core funds relative to their benchmark (dark blue line) together withcumulative return of five-year factor momentum strategy, where the best five factors (light blue line) or the best 10 factors (dark blueline) are owned as long-short positions among our 52 factors based on five-year factor performances in Russell 1000 universe.C l 16 f d i h f d i T i id d P i d f l i i f J
1520
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
11Joseph Mezrich, 212.667.9316, [email protected]
Currently, 16 quant core funds are in the fund universe. Transaction costs are not considered. Period of analysis is from January1989 through March 2011.Source: Nomura Securities International Inc., Bloomberg, Compustat, I/B/E/S, Russell, S&P and IDC.
U.S. Quantitative Research
Alpha similarities in quant and fundamental core investmentsAlpha similarities in quant and fundamental core investments
0.7Alpha correlation in quant and fundamental core funds
0.5
0.6
elat
ion
Aug 2007Quant meltdown
Quant core funds
0.3
0.4
-yea
r alp
ha c
orre
Fundamental core funds
0.1
0.2
Thre
e-
Notes: Shows three-year alpha correlation in quant core funds (dark blue line) and fundamental core funds (light blue line),where the average of all pairwise alpha correlations are calculated within each fund group. Currently, 16 quant core funds and48 fundamental core funds are in each fund universe Period of analysis is from January 2000 through April 2011
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
12Joseph Mezrich, 212.667.9316, [email protected]
48 fundamental core funds are in each fund universe. Period of analysis is from January 2000 through April 2011.Source: Nomura Securities International Inc., Bloomberg, Russell, S&P.
U.S. Quantitative Research
Factor momentum fuels quant value and growth funds
Quant growth fund alpha and growth-style factor momentum
q g
20
Quant value fund alpha and value-style factor momentum
15
20
25
30
35
10
12
14
16
Cumulative return g
row
th fu
nds
(%)
Growth-style factor momentum
25
30
35
40
12
14
16
18
20
Cumulative return
nt v
alue
fun
ds (
%) Value-style factor momentum
-10
-5
0
5
10
2
4
6
8
n of factor mom
entum
ulat
ive
alph
a of
Qua
nt
Aug 2007Quant meltdown
Quant growth funds10
15
20
25
4
6
8
10
n of factor mom
entum
mul
ativ
e al
pha
of Q
uan
Quant value fundsAug 2007
Quant meltdown
-20
-15
-2
0
2004 2005 2006 2007 2008 2009 2010 2011
m (%
)Cum
uNotes: Left chart shows cumulative average alpha (relative return to the benchmark) of quant value funds (dark blue line) together with cumulative return of five-year value-
0
5
0
2
2004 2005 2006 2007 2008 2009 2010 2011
m (%
)Cum
g p ( ) q ( ) g ystyle factor momentum strategy, where the best five factors are owned as long-short positions among our 34 value-style factors (value, earnings variability, GARP, andothers categories) based on five-year factor performances in Russell 1000. Right chart shows cumulative average alpha (relative return to the benchmark) of quant growthfunds (dark blue line) together with cumulative return of five-year growth-style factor momentum strategy, where the best five factors are owned as long-short positionsamong our 37 growth-style factors (growth, earnings sustainability [flipped polarity for earnings variability], GARP, and others categories) based on five-year factorperformances in Russell 1000. Transaction costs are not considered. Period of analysis is from January 2003 through 20 April 2011.Source: Nomura Securities International Inc., Bloomberg, Compustat, I/B/E/S, Russell, S&P and IDC.
13Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Alpha diversification among quant styles
16
18Alphas in Quant Core, Value and Growth funds
Quant Core funds
10
12
14
16
nt f
unds
(%
)
Q
Quant Growth funds
Quant Value funds
4
6
8
10
e al
pha
of q
uan
-2
0
2
4
Cum
ulat
ive
Aug 2007Quant meltdown
Notes: Shows cumulative median alpha (relative return to the benchmark) in large-cap core, value, and growth funds based on
-4
2004 2005 2006 2007 2008 2009 2010 2011
14Joseph Mezrich, 212.667.9316, [email protected]
quantitative methodologies. Currently, 16 quant core funds, 6 quant value funds, and 10 quant growth funds are in each funduniverse. Transaction costs are not considered. Period of analysis is from January 2003 through 20 April 2011.Source: Nomura Securities International Inc., Bloomberg, Russell, S&P.
U.S. Quantitative Research
Mood for quants is getting better?
Not only useful for alpha opportunities, quant strategies can provide diversification withdiversification with fundamental investments.
15Source: Pensions & Investments.
U.S. Quantitative Research
Outline : Examples of structural change in popular factors –
sources of ‘dinosaur’ risk
Selection for different objectives – examples of adaptive investing
• Factor momentum and the success of quants – dinosaurs?
• Low factor volatility and high factor momentum
• Risk parity for strategy combination
• Alpha repair – yet another adaptive strategy
16Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Combinatorics – a cheap approach to factor discoveryCombinatorics a cheap approach to factor discovery
20,000
12,000
16,000bi
nati
ons
4,000
8,000
Com
b
0
3 10 20 30 40 50
Number of factors
Notes: Shows number of combinations to select three factors from a different number of factors.Source: Nomura Securities International Inc.
17Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Return to low-volatility factor selection strategy
120
140
80
100
120
thly
ret
urns
, %
20
40
60
Cum
ulat
ive
mon
t
-20
0
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Note: Shows cumulative monthly returns to a strategy of selecting three factors out of 45 factors with the lowest last-one-year return volatilities. Universe isthe Russell 1000. Period of analysis is from January 1980 through end September 2010. Transaction costs are not considered. Past performance shouldnot and cannot be viewed as an indicator of future performance.Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
18Joseph Mezrich, 212.667.9316, [email protected]
U.S. Quantitative Research
Three strategies f t t (b t t ) l l tilit d bi tiThree strategies: factor momentum (best returns), low volatility, and combination
300
low volatilities Best Returns combined
150
200
250
hly
ret
urn
s, %
50
100
Cu
mu
lati
ve m
on
t
-50
0
1980
1981
1982
1984
1985
1987
1988
1989
1991
1992
1994
1995
1996
1998
1999
2001
2002
2003
2005
2006
2008
2009
Note: Shows monthly cumulative returns (top chart) and summary (bottom chart) of three strategies: (1) selecting three factors out of 45 with the lowest
low volatility best return combinedAnnualized Return 4.16 8.61 6.39Annualized Volatility 4.88 11.36 6.20Annualized IR 0.85 0.76 1.03
19Joseph Mezrich, 212.667.9316, [email protected]
y ( p ) y ( ) g ( ) g12-month return volatilities, blue line; (2) selecting three factors out of 45 with the best 12-month returns, red line; and 3) investing equally in strategies (1) and (2). Universe is the Russell 1000. Period of analysis is from January 1980 through end September 2010. Factors are constructed sector-neutral. Transaction costs are not considered. Past performance cannot and should not be viewed as indicative of future performance. Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
U.S. Quantitative Research
What gets selected using the low-volatility strategyg g y gy
20Joseph Mezrich, 212.667.9316, [email protected]
Note: Shows monthly factors (sector-neutral) selected using the lowest volatility strategy in the Russell 1000. At each point to time, there are three selectedfactors. The factor labels are sorted according to frequency of selection, with highest frequency at the bottom. Period of analysis is from January 1980through September 2010.Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
U.S. Quantitative Research
What gets selected using the factor-momentum strategyat gets se ected us g t e acto o e tu st ategy
21Joseph Mezrich, 212.667.9316, [email protected]
Note: Shows monthly factors (sector-neutral) selected using the highest factor momentum strategy in the Russell 1000. At each point to time, there are threeselected factors. The factor labels are sorted according to frequency of selection, with highest frequency at the bottom. Period of analysis is from January1980 through September 2010.Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
U.S. Quantitative Research
Priced and priceless —plow-volatility and factor-momentum strategies select different types
of factors
68%
77%
%
80%
90%
nfactor momentum low vol
32%40%
50%
60%
70%
ncy
of
sele
ctio
n
32%
23%
0%
10%
20%
30%
Fre
qu
en
Note: Shows frequency of price-related factor and non-price-related factor selection in (1) low-volatility strategy and (2) highest factor-momentum
0%
Non-Price factors Price factors
22Joseph Mezrich, 212.667.9316, [email protected]
Note: Shows frequency of price related factor and non price related factor selection in (1) low volatility strategy and (2) highest factor momentum strategy. Period of analysis is from January 1980 through September 2010. Universe is the Russell 1000.Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
U.S. Quantitative Research
Combining strategiesCombining strategies
180
200
220
Factor Momentum
Minimum Variance
Equal Weighted
120
140
160
y R
etur
ns, %
Risk Parity (unlevered)
Risk Parity (levered 1.5X)
80
100
120
Cum
ulat
ive
Mon
thl
20
40
60C
Note: Shows monthly cumulative returns of five strategies: (1) selecting three factors out of 45 with 60-month minimum variance, purple line; (2) selecting three factors out of 45 with the best 60 month returns red line; 3) investing equally in strategies (1) and (2) blue line; 4)
0
Nov
-88
Nov
-89
Nov
-90
Nov
-91
Nov
-92
Nov
-93
Nov
-94
Nov
-95
Nov
-96
Nov
-97
Nov
-98
Nov
-99
Nov
-00
Nov
-01
Nov
-02
Nov
-03
Nov
-04
Nov
-05
Nov
-06
Nov
-07
Nov
-08
Nov
-09
Nov
-10
23Joseph Mezrich, 212.667.9316, [email protected]
(2) selecting three factors out of 45 with the best 60-month returns, red line; 3) investing equally in strategies (1) and (2), blue line; 4) investing in (1) and (2) based on equal risk contribution, green line; 5) 1.5 times leveraged strategy (4), black line. Universe is the Russell 1000. Factors are built non-sector neutral. Period of analysis is from December 1988 through November 2010. Transaction costs are not considered. Past performance cannot and should not be viewed as indicative of future performance. Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
U.S. Quantitative Research
Combining strategies via dynamic risk parity weightsCombining strategies via dynamic risk parity weights
Weighted according to Risk Parity (FM: factor momentum; MV: minimum variance)1= 11 + = + = 1
Or write the weights in another way= + = +
Strategy Allocations
min variance (60 m)
best return (60 m) Equal Weighted
Risk Parity Weighting
Risk Parity Weighting (1.5X Levered)
Annualized Return 4.64 7.77 6.21 5.77 8.65Annualized Volatility 6.18 17.78 9.05 6.27 9.41
Note: Shows summaries of five strategies: (1) selecting three factors out of 45 with 60-month minimum variance, purple line; (2) selecting three factors out of 45 with the best 60-month returns, red line; 3) investing equally in strategies (1) and (2), blue line; 4) investing in (1) and (2) based on equal risk contribution, green line; 5) 1.5 times leveraged strategy (4), black line. Universe is the Russell 1000. Factors are built non-sector neutral. Period of analysis is from Dec 1988 through November 2010. Transaction costs are not considered. Past performance cannot and should not be viewed as indicative of future performance
Annualized IR 0.75 0.44 0.69 0.92 0.92
24Joseph Mezrich, 212.667.9316, [email protected]
cannot and should not be viewed as indicative of future performance. Source: Nomura Securities International Inc., Compustat, I/B/E/S, Russell, and IDC.
U.S. Quantitative Research
Alpha Repair – adaptive selection p p p
40
50
60
rns,
%
regression line
US 11.7% absolute return YTD 2011 Outperformed Russell 1000
10
20
30um
ulat
ive
Exce
ss R
etu
Model public
22 Jan 2007,US Alpha Repairmodel published
p81bps in April, 2011and 2.6% YTD 2011annualized outperformance:3.5% since 2007, model public3.3% past 5 yrs4.1% past 10 yrs
-10
0
Jan-
97
Jan-
98
Jan-
99
Jan-
00
Jan-
01
Jan-
02
Jan-
03
Jan-
04
Jan-
05
Jan-
06
Jan-
07
Jan-
08
Jan-
09
Jan-
10
Jan-
11
Cu model published
120
(%)_
60
80
100
retu
rn o
ver N
OM
UR
A 4
00 (
Model public
Regression line
JapanOutperformed NOMURA 40056 bp in April 20111.7 % in YTD 2011annualized outperformance:10.4 % since 2008, model public
0
20
40ec
-99
un-0
0
ec-0
0
un-0
1
ec-0
1
un-0
2
ec-0
2
un-0
3
ec-0
3
un-0
4
ec-0
4
un-0
5
ec-0
5
un-0
6
ec-0
6
un-0
7
ec-0
7
un-0
8
ec-0
8
un-0
9
ec-0
9
un-1
0
ec-1
0
Cum
ulat
ive
exce
ss
12 Sep 2008,Japan Alpha Repairmodel published
9.8 % past 5 yrs9.7% past 10 yrs
25
Notes: Shows cumulative monthly excess returns of Alpha Repair portfolios for U.S. and Japan. Past model performance should not and cannot be viewed as indicative of future performance; complete details available upon request. Transaction costs are not considered.Source: Nomura Securities International Inc., Compustat, I/B/E/S, IDC, Russell.
De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De Ju De
U.S. Quantitative Research
Alpha Repair – uncorrelated with other quant fundsp p q
0.6Alpha correlation in quant core funds and US alpha repair
Aug 2007
0.3
0.4
0.5
lati
on
Quant meltdownWithin Quant core funds
0.1
0.2
0.3
year
alp
ha c
orre
Between US alpha repair and Quant core funds
-0.2
-0.1
0
Thre
e-y
Notes: Shows three-year alpha correlation in quant core funds (dark blue line) and alpha correlation between quant core fundsand US alpha repair (red line), where the average of all pairwise alpha correlations are calculated in quant core funds.
-0.3
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
26
p p ( ) g p p qCurrently, 16 quant core funds and 48 fundamental core funds are in each fund universe. Period of analysis is from January2000 through April 2011.Source: Nomura Securities International Inc., Russell, S&P, Compustat, I/B/E/S, IDC, Bloomberg.
U.S. Quantitative Research
Any Authors named on this report are Research Analysts unless otherwise indicatedy p y
Analyst CertificationI, Joseph Mezrich, hereby certify (1) that the views expressed in this Research report accurately reflect my personal views about any or all of the subject securities or issuers referred to in this Research report, (2) no part of my compensation was, is or will be directly or indirectly related to the specific recommendations or views expressed in this Research report and (3) no part of my compensation is tied to any specific investment banking transactions performed by Nomura Securities International, Inc., Nomura International plc or any other Nomura Group company.
Conflict-of-interest disclosuresImportant disclosures may be accessed through the following website: http://www.nomura.com/research/pages/disclosures/disclosures.aspx . If you have difficulty with this site or you do not have a password, please contact your Nomura Securities International, Inc. salesperson (1-877-865-5752) or email [email protected] for assistance.
Online availability of research and additional conflict-of-interest disclosuresNomura Japanese Equity Research is available electronically for clients in the US on NOMURA.COM, REUTERS, BLOOMBERG and THOMSON ONE ANALYTICS. For clients in Europe, Japan and elsewhere in Asia it is available on NOMURA.COM, REUTERS and BLOOMBERG.Important disclosures may be accessed through the left hand side of the Nomura Disclosure web page http://www.nomura.com/research or requested from Nomura Securities International, Inc., on 1-877-865-5752. If you have any difficulties with the website, please email [email protected] for technical assistance.
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30Joseph Mezrich, 212.667.9316, [email protected]