What happens when you combine high performing quant strategies with high performing fundamental strategies?
Designing trading strategies around “Quantamentals” is a rapidly growing research area in trading and finance.
Today, in this issue of the Connors Research Traders Journal, we’re going to share with you an example of “quantamentals” at work. We believe you’ll like what you see.
The Strategy
Over time we plan on going much deeper on this topic. Today though, as a simple example, we are going to introduce a quantamental trading strategy designed to buy high-quality US companies in an uptrend.
Our strategy combines fundamental factors, in this case, quality, with technical/quantitative trading rules. This combination results in strong performance over the past 15 years, handily outperforming both the broad market and other stand-alone quality factor funds.
This strategy combines two well-known factors – quality, and relative momentum, into a complete trading strategy. We also apply a trend following regime filter on the index itself, effectively shutting the strategy off if the overall trend of the market is down.
What is Quality?
Quality is a well-known factor, or driver of abnormal returns. Academic and practitioner research has shown that companies that display “quality” characteristics tend to outperform in the long run.
The characteristics of “quality” companies are rather broad. Quality is typically defined as companies that have some combination of:
- stable earnings
- strong balance sheets (low debt)
- high return on equity
- high earnings growth
- high margins
In fact, the most famous investor in the world, Warren Buffet, applies the philosophy of buying high-quality companies that are cheap, essentially combining the quality and value factors.
How Will We Measure Quality?
For our strategy, we will focus on companies with high return on equity (ROE) ratios.
ROE is calculated by dividing the net income of a company by the average shareholder equity. Higher ROE companies indicate higher quality stocks.
ROE = Net Income / Average Total Common Equity
High ROE companies have historically produced strong returns. The following chart is from Standard and Poors. They ranked S&P 500 companies by ROE, then separated them into quartiles (four equal groups).
As can clearly be seen, Quartile 1, companies with the highest ROEs, have outperformed over the last 25 years.
Performance of Stand Alone Factor Funds
Factor investing, funds which look to profit from identified drivers of abnormal risk-adjusted returns, continue to attract assets at a record pace.
Most of these funds buy and hold stocks that qualify for a specific factor, be it momentum, value, quality, low volatility or others. These funds then typically hold these stocks until the next rebalance date, which is often quarterly, semi-annually or even annually.
Introducing “The Connors Research Quality Companies In An Uptrend Strategy”
Instead of just buying and holding “quality” companies, in our case companies with high ROE statistics, we are going to combine the fundamental quality factor with technical characteristics.
Specifically, once we identify our universe of “quality” companies, we are going to only buy those companies that have performed the strongest in the recent past, aka we only buy quality stocks that have strong momentum.
In addition to that, we also are going to apply a trend following regime filter. This is applied to the index itself (in this case the S&P 500) and is designed to effectively turn our strategy “on” and “off” based on the overall trend of the market.
We don’t take new buy signals if the overall market is trending lower.
Rules for The “Quality Companies in an Uptrend” Strategy:
- Stock Liquidity Filter. We start with a universe of the 500 most liquid US Stocks. This is determined by taking the 500 stocks with the highest average 200-day dollar volume, reconstituted every month. This universe will be very similar to the S&P 500.
- Quality (ROE) Filter. We then take the 50 stocks (top decile) with the highest ROE. This is our quality screen, we are now left with 50 high-quality stocks.
- Quality Stocks With Strong Momentum. We then buy the 10 stocks (of our 50 quality stocks) with the strongest relative momentum. We measure this by total returns for each stock over the past 6 months.
- Trend Following Regime Filter. We only enter new positions if the trailing 6-month total return for the S&P 500 is positive. This is measured by the trailing 6-month total return of the ETF SPY.
- This strategy is rebalanced once a month, at the end of the month. We sell any stocks we currently hold that are no longer in our high ROE/high momentum list and replace them with stocks that have since made the list. We only enter new long positions if the trend-following regime filter is passed (SPY’s 6-month momentum is positive). If the 6-month momentum of SPY is negative, no new entries are taken.
- Any cash not allocated to stocks gets allocated the SHY (1-3yr US Treasuries)
Results
Comment On The Results
The Connors Research Quality Companies In An Uptrend Strategy showed strong performance overall, especially considering the relatively simple/straightforward logic.
Our strategy outperformed the S&P 500 over this time frame by 7.1% per year with only slightly more volatility. The max drawdown of our strategy also is roughly half of the max drawdown for the S&P 500, which is due to our trend-following regime filter. Our strategy also witnessed an increased Sharpe Ratio compared to SPY over the last 15 years (0.83 vs 0.52).
Potential Improvements
As currently constructed, this strategy does not apply stops or take profit logic to individual positions. Would stops applied to individual positions improve performance? How about take profit rules, would that improve performance?
Stay tuned for future CRTJ articles where we will explore these opportunities.
Conclusion
Buying high-quality companies in an uptrend proved to be a robust and successful strategy over the last 15 years. We find improvements to single-factor funds, which typically buy and hold quality companies, by applying technical factors both in the form of quality stocks with high relative momentum as well as a trend following regime filter to keep us out of bear markets.
More research will be coming from us in the field of “Quantamentals”. Let us know if you’d like to see this research.
More Knowledge From Connors Research To Improve Your Trading
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