This entry was posted on November 4, 2013 by John Spence on Interactive Brokers Asset Management
Jonathan Tunney and John Bird at Atlas Capital are standing on the shoulders of giants in an attempt to deliver market-beating investment performance. For example, they leverage the research of Nobel prize-winning economics professor Eugene Fama in their enhanced indexing approach to investing.
Fama and collaborator Kenneth French in a seminal 1992 paper proposed the three-factor model that included size and value to explain stock performance.
“Those four factors are reliable sources of outperformance,” Tunney said during a recent webinar produced by Opal Financial Group.
Specifically, Atlas applies an enhanced-indexing strategy that falls somewhere between pure active management and passive, benchmark-based investing.
Tunney and Bird note that most active managers have a very difficult time outperforming their relevant index. For example, among U.S. large-cap equity mutual funds, nearly 80% have lagged the S&P 500 the past five years. The lack of persistence of manager outperformance paints an even bleaker picture.
“Based on historical performance, it is very difficult to determine the subset of active managers who will outperform ex-ante,” Tunney said.
“Investors should think about returns, volatility and alpha, or incremental return,” Bird added. “Then compare that to the fees they’re paying active managers, and think about what you’re paying for alpha.”
Enhanced indexing is different and lower-cost than pure active management. Enhanced indexing starts with the same universe as the benchmark but excludes, overweights or underweights certain stocks or sectors, or uses leverage, in an attempt to outperform the index. Specifically, Atlas Capital uses its four-factor approach for these decisions.
Small-cap and value stocks with low valuations tend to exhibit a performance premium over long periods, according to the research of Fama and French. In particular, the smallest and deepest-value companies tend to do the best.
Altas goes beyond size and value to include a momentum factor based on the 1997 research of Mark Carhart. Stocks with strong momentum to the upside during the previous 12 months tend to persist rising, and vice versa.
Finally, Atlas incorporates a short-term reversal factor that capitalizes on stocks’ tendency to overshoot in the short term, utilizing the 1990 work of Narasimhan Jegadeesh. In other words, stocks with the worst performance the past month tend to perform the best the following month.
Tunney and Bird pointed out that the momentum and reversal factors can trigger turnover costs and taxes.
“We are quantitative equity managers but we don’t blindly follow quant signals,” Tunney said during the webinar.
“We incorporate tax signals into our analysis as another factor,” Bird said. “We’re less inclined to sell positions with capital gains, and more inclined to sell positions if they have a loss. Will alpha outrun tax headwinds? It should.”