Investment Strategies: Style Rotation, Market Neutral, and More

Posted on May 2, 2024 in Economy

Strategic Asset Allocation

Strategic asset allocation is a long-term investment approach where investors set a target mix of asset classes in their portfolio based on risk tolerance and return objectives. It involves selecting and maintaining this mix over an extended period, periodically rebalancing to align with the original targets. The strategy emphasizes diversification to manage risk and forms the basis for an investment policy statement.

Total Value Added

Total value added is calculated as follows:

  • Allocation: ((Weight portfolio – Weight benchmark) x Return asset benchmark)
  • Selection: (Weight asset x (Return asset – Return benchmark))
  • Interactive: (Total portfolio return – (Benchmark return + Allocation effect + Selection effect))

Style Rotation and Main Equity Styles

Style rotation involves shifting investments between different equity styles based on expected performance. Main equity styles include:

  1. Value: Cheap, low P/E, low market-to-book, high-yield stocks
  2. Growth: More expensive, consistent growth strategy, earning momentum strategy
  3. Blend: More diversified portfolio, value-biased or growth-biased
  4. Small Cap: Investing in small-cap companies, popular with mutual funds
  5. Large Cap: Investing in large-cap companies, often outperforming small caps during recessions

Factor models can be used to identify styles of particular funds. Understanding when each style is outperforming allows investors to take advantage of excess returns.

Style Rotation Strategies

  1. Invest 100% in value (small) when it is expected to do better and switch to growth (large) when expected to outperform.
  2. Possibility of long/short investing with hedge funds.
  3. Based on forecast and successful market timing (consider transaction costs).
  4. Maintaining market-neutral positions: Balancing long and short positions to minimize market impact.
  5. Hedge fund: Meeting investors’ expectations of risk.

Constructing Style Portfolios

Example of creating a style portfolio using style rotation:

  1. Select a universe of stocks.
  2. Calculate P/E or price-to-book ratio for each stock and sort in ascending order.
  3. Choose stocks from the top of the list until reaching 50% of the total number (value stocks), the rest are growth stocks.
  4. Consider creating 3 or more portfolios for diversification.

Size and Style Indices

  • Size Indices: Russell 1000 (large caps) and Russell 2000 (small caps)
  • Style Indices: Russell 1000/2000 Value and Russell 1000/2000 Growth

Indices can reduce transaction costs related to portfolio construction and rebalancing.

Benefits of Style Rotation

Rotating investment styles in an equity portfolio offers several advantages:

  • Adapting to changing market dynamics
  • Capitalizing on varying performance of styles
  • Managing risk through diversification
  • Exploiting valuation opportunities
  • Navigating interest rate changes
  • Enhancing long-term performance
  • Providing active management opportunities

Market Neutral Strategy

A market-neutral strategy aims to generate returns independent of market direction by balancing long and short positions. The goal is to profit from relative movements between securities rather than overall market direction.

Equitizing Strategy

Equitizing involves investing in equity instruments to gain market exposure. It aims to capture overall market return, not to be market-neutral. Investors might use this strategy to temporarily gain equity exposure from cash or fixed-income positions.

Relative Value Strategy and Statistical Arbitrage

Relative value strategy exploits mispricing between related financial instruments. Statistical arbitrage, often involving pairs trading, identifies pairs of securities that historically move together. The strategy involves going long on the undervalued security and short on the overvalued one, expecting the price spread to converge.

Pairs Trading

Pairs trading is a type of statistical arbitrage using quantitative models to identify and exploit short-term mispricing between correlated assets. Traders capitalize on temporary divergences from the historical price ratio between the two assets.

Hedging Market Risk

Hedging market risk involves mitigating the potential negative impact of market movements on a portfolio’s value. Reasons for long/short hedging include:

  1. Downside risk protection
  2. Reducing volatility
  3. Enhancing risk-adjusted returns