Equity Valuation and Portfolio Management

CHAPTER 15

A Factor Competition Approach to Stock Selection

Joseph Mezrich, Ph.D.

Managing Director Nomura Securities International, Inc.

Junbo Feng, Ph.D.

Vice President Nomura Securities International, Inc.

Successful investing is difficult because of the rarity of durable investment strategies. The plain fact is that strategies fail despite the support of logic or history. The approach we introduce in this chapter confronts the problem of strategy failure as an expected feature of investing. Every investment strategy has three core properties: (1) the return that the strategy generates, (2) the volatility of that return, and (3) the correlation of that return with alternate strategies. The problem we address is the fragility of the first property, the source of reward uncertainty. Our solution is derived by exploiting the second and third properties, the more persistent risk features of investment strategy. Mainly we exploit the persistence of correlation of investment strategies to counter the lack of persistence of the return to investment strategies.

The goal of our approach is to provide a systematic framework that removes failed strategies from the playing field until they prove worthy, while providing an opportunity for new strategies to join the team.