CAIA Level II: Advanced Core Topics in Alternative Investments, 2nd Edition

37.5 A STYLIZED QUANTITATIVE EQUITY STRATEGY

This section contains a simple exercise that highlights some useful techniques currently employed within a quantitative equity market neutral strategy. The Fama-French three-factor model is one of the tenets that EMN managers should understand. The model consists of three factors: Mkt-RF, SMB, and HML. Mkt-RF represents excess returns on the market (or excess returns from the market proxy, typically the S&P 500). SMB is a size strategy, with a long portfolio of small-capitalization stocks and a short portfolio of large-capitalization stocks. HML is a value strategy, with a long portfolio of high book-to-market stocks and a short portfolio of low book-to-market stocks. Further, EMN managers should understand the momentum factor as reported by Carhart.

This exercise begins with the three factors: Mkt-RF, SMB, and HML. The potential benefits of combining these strategies have been demonstrated by the historical low correlation across strategies and the improved overall portfolio returns per risk. EW is a portfolio that represents an equally weighted or neutral exposure to the three factors. The EW portfolio is rebalanced once a week.1

Exhibit 37.3 demonstrates the improved reward-to-risk ratio (Ann.Ret/Ann.Std) results of the EW portfolio relative to the returns of the three portfolios that are highly exposed to the three return factors (market, size, and value). Notice the low correlations of weekly returns across the three factors (0.06, ...