Do Element Models Live On Inwards The Curt Term?

Besides pair-trading, “factor model” is the close pop workhorse of the statistical arbitrageur. In a previous article, I discussed the close well-known ingredient model – the Fama-French Three-Factor model, alongside the full general marketplace index returns, the market-cap of the stock, too the book-to-price ratio equally the exclusively iii factors driving returns. However, equally I explained earlier, this ingredient model has a really long horizon. For the quantitative trader who needs to brand coin every month, the natural instinct is to expect for a to a greater extent than “sophisticated” ingredient that plant inwards the brusk term, or fifty-fifty to railroad train roughly variety of model that role dissimilar factors every calendar month inwards answer to “market condition”. Alas, other than hearsays too second-hand gossips, I accept never witnessed an actual success of this approach inwards a hedge fund or proprietary trading grouping – at to the lowest degree a success that lasts for to a greater extent than than a year.

I am of course of didactics non privy to the electrical flow surgical procedure numbers of ingredient models run past times roughly of the close successful hedge funds today. However, in that location is a shape of ETF (called “XTF”) marketed past times PowerShares Capital Management that uses a similar ingredient approach for its stock pick criteria. According to media reports, each stock inwards these XTF’s is scored past times 25 variables such equally cash flow, earnings growth, cost momentum, etc. This sounds similar a classic ingredient model to me. This model is reportedly designed past times the quantitative unit of measurement at American Stock Exchange. To abide by out if they accept indeed discovered the holy grail of ingredient models, I looked at the surgical procedure of these XTF compared to their benchmarks.

Here I tabulate the XTF’s for each marketplace cap too value category, their corresponding benchmark marketplace index ETF’s, too finally the YTD differential returns upwards to Dec 13, 2006. (PJG too PJM accept equally good brusk a history for this comparison.)

	Value	Blend	Growth
Large cap	PWV-IVE=4.8%	PWC-IVV=-3.6%	PWB-IVW=-5.0%
Mid cap	PWP-IJJ=0.1%	PJG-IJH=N/A	PWJ-IJK=3.1%
Small cap	PWY-IJS=-0.7%	PJM-IJR=N/A	PWT-IJT=-4.9%

The differential returns are all over the place: roughly positive, others negative. To me, this is symptomatic of a ingredient model that does non accept predictive power. (After all, if the differential returns are consistently negative, nosotros could accept long the ETF, brusk the XTF, too brand consistent profits!) At the really least, this ingredient model may accept a horizon much longer than what close traders would live interested inwards – inwards which case, why non but role the uncomplicated Fama-French model?

This is non to tell that exotic, proprietary ingredient models accept no use: they tend to live pretty useful for peril management, equally volatilities too correlations are ofttimes easier to predict than returns. But beware every fourth dimension your peril administration software vendor tries to sell yous an alpha generator!