INVESTOR PRESENTATION

Systematic
Fundamental Equity Models
New Directions
Prepared for FactSet Symposium 2015

Systematic Fundamental Models: New Directions

Differing views on the state of quant equity

Are fundamental models still valuable or do we all need to move to scraping big
data, NLP and machine learning?
Camp1: If you find a factor that has a great story, great data, and that no one else is on to
yet, that's alpha. If you implement the big four better than someone else, that's alpha.
Cliff Asness
Camp2: scientific investing, as a superior sub-set of quant, should focus on identifying
new investment ideas and continually improving their implementationHowever, a new
idea should not be confused with just another signal that captures a value premium in a
slightly different way to all the others --- Ron Kahn

Fundamentals, attention and sentiment still drive relative values. Good insights and
careful modelling can be used to extract alpha from fundamental data
Skill modelling, conditioning and contextual analysis
Better models using customer/competitor relationships
Extending models to industry and country returns and dynamic signal timing

Rise and Fall of Accruals Anomaly: Live vs. Backtest

Live Trading at AG
Backtest from 2002

Source: AG. US All-Cap universe monthly decile spreads of returns adjusted for systematic risk factors.

Accruals in Europe: Live vs. Backtest

Live Trading

Source: AG. EU All-Cap universe monthly decile spreads of returns adjusted for systematic risk factors.
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Academic Research on Idea/Signal Decay

Recent papers (Green, Hand and Zhang (2013), Mclean and Pontiff (2014), Harvey,
Liu and Zhu (2015)
Decay out of sample ~25%
Decay post publication on SSRN ~30%
Significant evidence of trading and decay of predictive ability, however residual
predictive ability remains

Output rate for new research has

increased substantially over the last
decade, as has data mining risk

Behavioral sources that generate

mispricing are sticky (Barber and
Odean, 2011)
Green, Hand and Zhang (2013), The Supraview of Return
Predictive Signals.

Framework for Discussion

Basic linear factor model (Rosenberg/Grinold) framework

Includes country, industry and other systematic factors
k

Ri ,t rf t = j ,i f j ,t + i ,t
j =1

Typical signal processing setup

1. Winsorize and standardize the fundamental ratio
2. Decompose into country, industry, factor projections and residual component
(neutralize)
3. Rescale residual to stdev=1 and evaluate residual as return predictor via tile
spreads and FM factor returns

Implementation of Alpha: Example of

Even for the well know signals from academia, careful implementation can improve
the signal to noise ratio and IR relative to generic versions.

Example: Change in asset turnover ()

= 4

=3

A common fundamental signal, and a component of Piotroskis F score

Common implementation pitfall: it suffers from being scaled by the time-series
volatility of asset turnover
Solution: Re-scaling the signal by the inverse of its asset turnover volatility

1
=
()
20
=19
1
=
( )

Change in Asset Turnover Pre/Post Volatility Scaling

Source: AG. US all-cap universe monthly decile spreads of returns adjusted for systematic risk factors.
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Skill Modeling As a Framework for Improving Signals

What is Skill Modelling?

=
: asset volatility
z: normalized forecasting score
IC: information coefficient. Usually assumed to be constant

Now we expand this formula to incorporate ideas of contextual analysis:

= ()
() : a function of fundamental characteristics = (1 , 2 , , )

What is in :
Growth and profitability proxies
Earnings predictability and information uncertainty
Value/growth life cycle proxies
Country, industry and size
Why Skill Modeling?
Better signal attribution and ease of diagnosing out of sample performance
Parsimonious models generate non-linear effects and dynamic variation in effective
signal weights

Skill Modeling: Example

Consider a simple measurement of topline growth:

Intuitively, we include asset growth as a conditioning variable

Recent top-line trends matter most for growth investors. Holders of lower PE
stocks care more about earnings, i.e. sales*margin

( 1 )
=

Sigmoid Weighting Function

IC Function

Realized IC

Realized 3-Month IC

Asset Growth Group Rank

Asset Growth Score (Normalized)

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Performance: Sales Growth Pre/Post Skill Model

Source: AG. US all-cap universe monthly decile spreads of returns adjusted for systematic risk factors.
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Performance: US Accruals Pre/Post Skill Model

Asset and sales growth

conditioning added

Source: AG. US all-cap universe monthly decile spreads of returns adjusted for systematic risk factors.
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Using Customer/Competitor Relationships to Enhance Models

Customer and competitor relationship data

be utilized for more focused models and to
capture lead-lag relationships

Customer
sales
growth

Customer sales growth positively predicts

returns, as does competitors sales growth
acceleration
Simple linear combinations improve on
industry-relative measures, and skill
modeling can lead to further improvement

Firm
specific
sales
growth

Combined
Model

Competitor
trend in
sales
growth

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Relationship Based Sales Growth

Source: AG, FactSet. US Revere universe monthly decile spreads of returns adjusted for systematic risk factors.
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Competitor Neutralized EBITDA/EV

Source: AG. US all-cap universe monthly decile spreads of returns adjusted for systematic risk factors.
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Industry and Country Predictions

Bottom up analysis for many fundamental ratios can generate useful signals for
predicting industry and country returns
Low breadth and IR, but attractive return spreads
Statistical analysis is less conclusive
Weak significance requires more conviction in the idea

Weighted FM regressions with industry factor returns as the dependent variable is a

useful framework
Differs meaningfully from predicting industry cap-weighted returns
Down-weight more variable industry means/coefficients
De-emphasize thin industries in the analysis

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Dynamic Weighting of Signals

Becoming the norm rather than the exception, at least in marketing materials
Value spreads are intuitive, but the empirics arent robust
Adjusting for differences in forecast earnings growth is important.
When growth expectations are less diverse in the cross section, then value
spreads should be tighter.
Time series scoring can help
Other approaches
Structured empirical models, i.e. Kalman filters
Machine learning not well suited to intermediate or low frequency cycles and
longer forecast horizons, but potentially effective where there is good time-series
breadth

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Summary

Fundamentals, and their effects on attention and sentiment, remain the key driver of
relative price discovery for equities

Generic models from academic working papers experience decay out-of-sample, but still
provide valuable starting points for investors who can combine investment expertise with
sound empirical modeling

Our skill modeling framework allows for significant improvements in performance by

conditioning forecasts on important characteristics

Company relationship databases open up new possibilities for better models of relative
fundamental trends

Relative to machine learning approaches, structured fundamental analysis is far less likely
to result in over-fitting
The added complexity is motivated by fundamental insights
Attribution can easily separate generic factor performance from the conditional skill
components

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