Beating The Market With Value And Momentum - The Lion Portfolio (Part I)

by: Tal Davidson

Summary

The objective: Beat the market over the long term.

The method: Quantitative Value & Momentum.

The evidence: This portfolio returned 19% per year (in a backtest of 18 years).

Part I of the series on The Lion Portfolio - my All-Cap Quant Value & Momentum Model Portfolio.

In Seeking Alpha, we are all seeking for... well, Alpha.

Down to our fundamental goal - we seek systems that will help us beat the market over the long term.

While beating the market is our primary goal, it is not our only requirement. We should be searching for a system to beat the market, on an after-tax after-fees basis, and do so with low volatility and low maintenance on our side.

Previously, I presented the simplest way to beat the market in a series of SA articles. In this article, I'd like to present the ultimate way to do so.

The Lion Portfolio meets all the requirements stated above. Based on elaborate academic research and extensive testing, it has delivered significant after-tax after-fees outperformance, and have done so with rather low volatility and low asset turnover.

In this series of articles, I will discuss what it is, and how investors can devise a similar portfolio (or clone mine) to achieve similar results. In Part 1 of the series, I shall present its main attributes and its historical performance.

The Lion Portfolio

The Lion Portfolio is a quantitative all-cap Value and Momentum portfolio. Over the last 18 years, in a backtesting simulation, it returned a whopping 19% per year, on average. A $100,000 invested in it in 1999 would have grown to more than $2,300,000 in 2017.

The Lion Portfolio is well diversified to help reduce risk and volatility. It contains 50 stock holdings - 30 Value stocks and 20 Momentum stocks.

Moreover, it requires only minimal maintenance. The Lion Portfolio needs rebalancing only once every six months, which is enough to keep the portfolio healthy.

The Lion Portfolio has four main characteristics:

1. Reliance on hard facts, not notions - The algorithms of the lion portfolio are based on data-driven academic research spanning more than 25 years.

2. A systematic rule-based portfolio - Helps you avoid cognitive biases and behavioral mistakes.

3. Keeping it simple - Long-only portfolio, no OTC, no shorting, no margin, no options, no financial engineering, no complications.

4. Long-term orientation - Accepting short-term underperformance. It will not beat the market every day, not every week, not every month, even, not even every single year. But it has the best chances of beating the market over the long term.

How Has The Lion Portfolio Performed?

The Lion Portfolio is based on quantitative algorithms which are inspired by cutting-edge academic research and have been tested extensively. While I will dive deeper into the theory and implementation of those algorithms in future articles of the series, I would like to begin here by presenting the algorithms' outcome.

I have used Portfolio123.com's platform to backtest the Lion Portfolio and present the results herein. My simulation spans 18 years, from June 30, 1999, to June 30, 2017.

As shown in the chart above, the Lion portfolio returned 18.97% per year, on average, over a period of 18 months. An investment of $100,000 in the Lion portfolio in mid-1999 has gained 2,180% over this period, vs. merely 146% for the S&P 500. The Sharpe ratio came in substantially high, at 1.41, even compared to other leading quant strategies.

A unique characteristic of the Lion portfolio is its low Asset Turnover. Asset Turnover is the percentage of stocks that are replaced every year, on average. In our case, the turnover is only about a third of the portfolio. Since we're holding 50 stocks or so, we will have to replace every year about 16 stocks. Throughout the years that I've been designing quantitative strategies, I saw many allegedly compelling quantitative strategies, only to discover that many of them had an excessive asset turnover, sometimes north of 100%. A high asset turnover rate is an indication of a poorly design quant strategy. The high turnover will result in high accrued transaction costs and excessive tax bill, diminishing after-fees after-tax returns.

Yet the best part of the Lion portfolio is its volatility. It is magically low, as shown in the tables below.

The tables above compare the performance of the Lion portfolio ("Model") to that of the S&P 500, its Quantitative Momentum portion, and Quantitative Value portion, respectively.

Let's examine the standard deviation of the Lion portfolio compared to the standard deviation of both the quantitative value and the quantitative momentum portfolios. It is lower than both. The reason for that is a well-known mathematical phenomenon - When you have two random variables, in our case - the price behavior of two portfolios, which are not fully correlated, the fluctuations of one even out the fluctuations of the other. When Quantitative Value has a bad day, Quantitative Momentum compensates for it with positive returns. When Quantitative Momentum declines on another day, Quantitative Value comes in with a positive return. Of course, that mechanism doesn’t happen every day, but it happens enough to lower the overall volatility of the portfolio. The two are better than one. Momentum and Value are better together.

Not only the drawdowns of the combined model are lower than each of its components, Value & Momentum, it is also surprisingly lower than that of the S&P 500. The superior Sharpe ratio of 1.41 is an indication of uncompromised expected returns, coupled with loosely correlated volatility profiles.

Let's now examine the year-over-year and month-over-month returns profile. The following charts show the Lion portfolio's ("Model") Monthly and Yearly performance compared to the S&P 500 ("Benchmark"). The excess is the difference between the two.

The charts clearly show the superior performance of our All-cap Value & Momentum Lion Portfolio. The combined portfolio beats the S&P 500 almost every year. And when it doesn’t, such as in 2014 or 2009, it lags by a very low margin. 1999 is an exception. It was such a bad year for value investing that every value portfolio suffered, including that of the mighty Warren Buffett.

It is interesting to note the low correlation of monthly returns of the model and the benchmark. The model lags the market in three out of the twelve months, by up to -2.57%. An investor in the Lion portfolio must develop a long-term orientation and weather short-term volatility.

Coming Up Next

In the next articles of this series, I will delve into the portfolio's two components: Quantitative Value & Quantitative Momentum. We will discuss the outperformance mechanism of each one, and why they are likely to continue outperforming going forward. We will then open the black box and look at some of the holdings of the Lion portfolio. I invite you to follow my profile so that you do not miss it.

(source of all charts: portfolio123.com)

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.