Quant Concepts: Low Beta Momentum

Volatility getting too much but still want to participate in the price action? This strategy has been just right.

Phil Dabo 29 October, 2021 | 4:28AM
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Phil Dabo: Welcome to Quant Concepts' working from home edition. During last week's Quant Concepts video, we looked at a strategy that focused on price momentum and predominantly used the 50 and 200-day moving averages. We found really good returns, but we also found that the strategy had a lot more volatility and much higher turnover.

With the one-year return on the S&P/TSX of approximately 25%, some investors might be looking to de-risk their portfolio with stocks that have lower volatility but still want to participate in some of the momentum in the stock market. Today, let's take a look at a strategy that focuses on stocks that have lower volatility but have high price momentum.

As always, let's start by selecting our universe of stocks, which includes all 700 stocks in our Canadian database with a complete data set. Next, we are going to rank our stocks from 1 to 700 according to five key factors.

Our two main factors are used to reduce volatility, and that's using the beta and the 180-day standard deviation to reduce price risk. The next three factors are based on price momentum. We have the price relative to the 50 and 200-day moving averages which are very popular technical indicators that are meant to identify stocks that are in an uptrend. Our third momentum factor is the price change relative to 12-month high because it's a good momentum variable with downside protection. We've found that certain stocks that are trading close to their previous 12-month high have tended to perform well.

Now that we have our stocks ranked from 1 to 700, we are going to go through our screening process, starting with our buy rules. We are only going to buy stocks that are ranked in the top 50th percentile of our list. We also want to reduce the amount of market risk in the portfolio. So, we've placed a limit of 1 on beta. A stock with a beta of less than 1 is expected to have a price that moves less than the market. In this case, I'm referring to the S&P/TSX as the broader market.

We don't want any microcap stocks in the portfolio. So, I've placed a minimum market cap of 588 million, and I used the average monthly volume traded for a stock to make sure that they have enough liquidity. The average monthly volume traded has to be greater than the median for our investable universe. Our last buy rule is the Morningstar quantitative financial health score in order to identify companies that have strong balance sheets. This is a proprietary metric that measures the probability that a firm will fall into financial distress or default on its obligations. We want stocks that are ranked in the top third based on the financial health score.

Now, let's take a look at our sell rules, which are very simple. We are going to sell stocks if they fall out of the top 50th percentile of our list, and if the beta goes above 1. We are also going to sell stocks if their financial health deteriorates and falls out of the top third of our list.

Now, let's take a look at performance. We tested this strategy from January 2006 to September 2021. Over this time period, this strategy generated a very strong 11.3% return, which is 8% higher than the benchmark and only a 32% annualized turnover. We can see by looking at the annualized returns that this strategy has performed well over longer periods of time. It's also worth noting that this strategy has only been negative twice over the past 10 years. In both periods, the strategy performed better than the benchmark.

We can see by looking at the standard deviation that this strategy has lower price risk than the benchmark, and that contributes to a very strong risk-adjusted return as you can see by the Sharpe Ratio. As expected by a lower volatility strategy, this strategy has lower market risk, as you can see by beta.

When looking at this performance chart, we can see very good outperformance by the strategy over time. And more importantly, when looking at the up and downside capture ratios, we can see that this strategy has performed well by outperforming during down markets.

This is a great strategy to consider if you're unsure about the future performance of the stock market. We've seen a lot of momentum in the S&P/TSX over the past year, and some investors are looking to protect their investments from downside risk in case there's a reversal in the stock market. The buy list for this strategy has a blend of stocks that have lower volatility in case the market goes down and incorporates price momentum in case the market continues to go up. You can find the buy list along with the transcript of this video.

From Morningstar, I'm Phil Dabo.

Find the buy list here.

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Phil Dabo  Phil Dabo is Director, CPMS Sales

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