Dynamic Factor WeightsDynamic Factor Weights

Red Devil PartnersJoon Seong Choi, Youngjun Yoo, Richard Park, YK Kim

Overview

• Our purpose is to develop a stock selection strategy in order to outperform S&P 500.

• Our analysis includes both fixed and dynamic factor weights.

Source Data* Universe 　 　

　 * Universe Formula SP_500

　 * Benchmark 　 Same as Universe

* Time Series 　

　 * Start Date 01/01/2000

　 * End Date 12/31/2005

　 * Calendar US COMPOSITE

　 * Universe 1 - Month

　 * Main Returns 1 - Month

　 * Factors 1 - Month

　 * Weights 1 - Month

* Return Sources 　

　 * Universe Return Sources Compustat;

　 * Benchmark Return Sources

Compustat;

　 * Risk Free Rate Return Sources

US - Disc. Rate 91D T-bill;

　 * Include Dividends Yes

　 * Currency U.S. Dollar

Steps

1) Specify list of factors

2) Univariate screens

3) Identify 5 fractiles for each factor

4) Choose significant portfolios

5) Optimize weights for portfolios with S&P500 volatility

6) Compare fixed weight strategy and dynamic weight strategy

-5

0

5

10

15

20

25

30

Cash to P D/E LTGrowth

Est.

Mcap NI 3yrGrowth

P to Book PriceMom

ROE Sales Rev Reinvest

1st 5th

Factor Returns

Identified factors

Factors (1m lagged)

- Cashflow to Price

- Debt to Equity

- Market Capitalization

- Price to Book

Factor Screen

- 0.03

- 0.02

- 0.01

0

0.01

0.02

0.03

0.04

- 1- - 2- - 3- - 4- - 5-

- 0.03

- 0.02

- 0.01

0

0.01

0.02

0.03

0.04

0.05

0.06

- 1- - 2- - 3- - 4- - 5-

- 0.05

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

- 1- - 2- - 3- - 4- - 5-

Cashflow to Price(5) : value weighted Debt to Equity(5) : value weighted

0

0.05

0.1

0.15

0.2

0.25

0.3

- 1- - 2- - 3- - 4- - 5-

Market Cap(1) : equal weighted Price to Book(5) : equal weighted

Optimization: fixed weights

• Form a portfolio with same volatility of S&P500

Return StdCashtoP(5) -0.20% 5.24%DtoE(5) -0.20% 6.87%MKTCap(1) -0.01% 4.36%MKTCap(5) 2.26% 6.4%PBK(5) 2.07% 6.3%SP500 0.0011% 4.39%

Correlation Matrix

Variable CTP_5 DTE_5 MCAP_1 MCAP_5 PBK_5 SP_500

CTP_5 1.000

DTE_5 0.831 1.000

MCAP_1 0.953 0.863 1.000

MCAP_5 0.832 0.618 0.815 1.000

PBK_5 0.797 0.530 0.788 0.954 1.000

SP_500 -0.029 0.097 -0.013 -0.092 -0.158 1.000

Weights CTP_5 DTE_5 MCAP_1 MCAP_5 PBK_5 SP_500 SUM-1.3866208 -0.352199 2.313 0.561965 -0.136616 1

Portfolio Return 1.32%Std 4.39%

Dynamic weight strategy

Add dummy variables3 months S&P500 momentumIn negative momentum, buy more portfolio with negative correlation with S&P500 (Price to book (5))

Optimization: dynamic weights

• Form a dynamic portfolio with same volatility of S&P500

Return StdCTP_5 -0.20% 5.24%DTE_5 -0.20% 6.87%

MCAP_1 -0.01% 4.36%MCAP_5 2.26% 6.44%

PBK_5 2.26% 6.27%PBK_5__Dummy 1.3820% 5.63% SP500 std 4.40%

Correlation Matrix

Variable CTP_5 DTE_5 MCAP_1 MCAP_5 PBK_5 PBK_5__Dummy

CTP_5 1.000

DTE_5 0.830 1.000

MCAP_1 0.953 0.862 1.000

MCAP_5 0.831 0.618 0.814 1.000

PBK_5 0.796 0.531 0.787 0.954 1.000

PBK_5__Dummy 0.731 0.564 0.703 0.831 0.870 1.000

Weights CTP_5 DTE_5 MCAP_1 MCAP_5 PBK_5 PBK_5__DummySUM-1.5513984 -0.327491 2.17962 0.509 -0.248882 0.439625 1

Portfolio Return 1.56%Std 4.40%

Results

0

50

100

150

200

250

300

350

1-01-2000 7-01-2000 1-01-2001 7-01-2001 1-01-2002 7-01-2002 1-01-2003 7-01-2003 1-01-2004 7-01-2004 1-01-2005 7-01-2005

SP 500 Fixed Weights Dynamic Weights Fixed Weights (without short) Dynamic Weights (without short)

Conclusion

Multi-factor model strategy outperforms universe return (e.g. S&P500)

Dynamic weight strategy outperform fixed weight strategy

Future consideration:Transaction cost should be considered to evaluate strategies