DIVERSIFIED VALUE (USA) LONG/SHORT

The Diversified Value (USA) Long/Short strategy is quantitative stock portfolio of up to 75 securities hedged with S&P500 futures. Over the prior 10 year period to August 2013, simulated strategy performance was 17.1% per annum on a hedged basis, compared to a return of 6.9% for the S&P500 (inclusive of dividends). Maximum drawdown was 18.2% over this period which included the GFC. Results are shown graphically in the table below.
FIGURE 1 - 10 YEAR STRATEGY PERFORMANCE

LIQUIDITY
Portfolio composition was limited to stocks with an average daily turnover of at least $500,000. Transaction cost assumptions were assumed to be 0.15% inclusive of brokerage and slippage. Stress testing with transaction costs as high as 0.30% has been performed and does not materially degrade performance.

DIVERSIFICATION
The portfolio is well diversified across 75 equity positions, rebalanced monthly. Sector and industry concentrations are constrained to ensure the portfolio is not overly concentrated in any one part of the economy. Portfolio construction utilizes a number of selection criteria including value, growth, momentum, quality and sentiment styles. The success of each style varies through time, however relying on multiple style factors further diversifies portfolio risks. Monthly performance is summarised in Figure 2 with annualised performance totals for each year.

FIGURE 2 - 14 YEAR MONTHLY PERFORMANCE SUMMARY

Jan 19 9 9 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2 0 10 2 0 11 2 0 12 2 0 13 0.64% 4.82% Fe b Mar -3.47% 0.63% 2.62% A pr 7.57% 4.54% 1.09% May J un J ul A ug Sep Oc t N ov Dec Tot a l 0.26%

7.39% -0.43% -1.16% 8.50% 2.72% 6.11% 9.99% 5.75% 3.36% 4.36% 4.04% 1.80% -0.41% 3.23%

3.04% -3.85% 4.40% 2.54% -3.03% 5.12% 0.83% 5.59% -0.36% -2.08% 4.73% 6.29%

0.53% -8.93% 2.01%

0.01% -0.47%

1.46% 10.24% 6.44% 5.02% 1.83% -1.65% 0.06% 0.48% -1.18% 2.10%

4.25% 14.48% 6 0 . 15 % 4.98% 7 2 . 6 0 % 1.32% 3 6 . 5 8 % 0.46% 4 5 . 15 % 2.05% 2 6 . 5 9 % 0.73% 15 . 16 % 2.60% 2 7 . 3 2 % 2.63% 13 . 2 2 % 1.23% 5 . 15 %

4.84% 12.34% 7.20% 5.62%

7.11% -2.07%

4.69% 13.86% -0.84% 3.19% 2.77% 5.07% 0.86% 5.46% 0.44% 5.58%

1.23% -6.64% -4.86% 1.71% 3.86% 1.98% -2.19% -0.12% 6.14% 1.05% -1.73% 3.30% 4.26% 6.44% 2.16% -0.91%

3.18% -3.88% 3.84% 1.29% 12.27% 1.78% 0.35% 0.21% 0.04% -1.79% 3.60%

-1.12% -4.27% 6.70% 4.34%

1.68% -0.54% 1.80% 1.92% 5.80% 2.94% 0.74% 0.36% 5.12% 5.18%

3.13% -3.27%

0.27% -0.77% 8.74% 3.54% 2.87% 2.12% 6.93%

-0.41% -2.66% -3.20% -0.79% 4.01% 4.85% 8.95% -8.12% 4.31% 9.66% 1.86% 2.53%

-2.17% -9.74% 0.71% -1.72% 5.61% 4.65% 4.70% 4.75% 0.27% 1.13%

6.17% 2 7 . 0 5 % 4.12% 2 2 . 0 7 %

-1.93% -7.04% -1.45% -1.48% 3.28% 1.21%

3.69% -5.30%

-3.33% -7.06% -6.22% -2.20%

0.37% -2.40% - 6 . 2 4 % 1.37% 0.17% 5.72% 25.96%

-2.51% -4.62% 0.20% 5.07%

3.72% -0.95% -0.23%

4.99% -0.50%

HEDGING STRATEGY
In formulating a hedging strategy it is recognised that market risks are always present and therefore some hedging is desirable to reduce volatility and drawdowns. In addition, risks to equity holders are increased during periods of deteriorating economic conditions and where equity market valuations become stretched. To address these objectives, a hedging strategy employing equity index futures was chosen. To reduce drawdowns and volatility, 50% of long exposure was hedged at all times. To address additional risks, hedging was increased to 100% in either of the following scenarios: 1. Earnings estimates are declining for the market as a whole 2. The market risk premium is less than 2%, indicating limited additional returns for stock market investors as compared with fixed income alternatives. Equity index futures were chosen for hedging due to the significant transaction cost and liquidity advantages in implementing the timing component of the hedge strategy. Figure 3 shows the impact of hedging on overall portfolio returns and risk measures.
FIGURE 3 10YR PERFORMANCE IMPACT OF HEDGING

Long Only Long/Short Return p/a 19.7% 17.1% Standard Deviation p/a 19.9% 14.2% Sharpe 0.84 0.99 Max Drawdown -51.1% -18.2%

MODEL DEVELOPMENT
Strategy development focused on US markets due to ready access to data for this region. Similar studies can be made in Europe and Asian markets with provision made for the required data sets. To ensure results are credible, quantitative selection criteria were kept simple and intuitive. A number of investable universes were considered to validate the strategy across different market characteristics such as size and liquidity. In all cases pre-trade liquidity filters were applied to avoid spurious results from untradeable portfolio selections. Further details on the portfolio construction process are available as part of the due diligence process.

CAPACITY
Given the liquidity threshold of $500K per day for stocks in the investible universe, an indicative capacity of $17million is proposed for this strategy. This threshold is based on the following assumptions: Min Daily T/O per stock $500K Max Share of Total Volume: 15% Max Time to trade into/out of positions: 3 Days Number of Positions: 75 Stocks

SUMMARY
This paper outlines a purely quantitative strategy for selecting stocks based on a diversified factor model. This approach significantly outperformed benchmarks over the period considered in both hedged and unhedged scenarios. In the hedged version, the strategy returned 17.1% p.a. over 10 years with an inter-month drawdown of only 18%. Over 14.5 years the return increased to 23.2% p.a. with a Sharpe Ratio of 1.4

CONTACT
For more information contact Nick Ireland (Phone) +61 413 195 126 (Email) njireland@gmail.com