The Quantamental Investing Process – How we build and manage portfolios

The QVGS Framework defines principles at the market, portfolio, and security levels useful for creating and managing portfolios across asset classes and market segments.

Managing portfolios is a continuous endeavor. This requires us to follow a strategy-based approach to generate returns from different sources and be system-driven to manage risk.

At Modulor Capital, we run 3 processes created using the principles of the QVGS Framework to operate portfolios like clockwork on a weekly, monthly, and quarterly basis:

  1. The Tactical Management process for timing the markets,
  2. The 3 Flag process for rejecting, ranking, and selecting securities, and
  3. The Risk Management process to optimize exposure.

Process-I: Tactical Management

Investor returns are dependent on the initial set of conditions when investing. Investors will get better returns if they enter when the markets are low than if they enter when the market is high. Therefore, the first question to ask when deploying capital is:

Whether it is a good time to invest or not?

Incidentally, it is also one of the most difficult questions to answer. This is where the QVGS Framework’s market-level Principles of (i) Market Cycles, (ii) Forecast Window, and (iii) Alternate Assets come into play.

Market Cycles

Markets move in cycles. To an untrained eye, these cycles are an increase (Bull Market) or decrease (Bear Market) in the value of the index. However, there are many more ways of describing these cycles. We use three –  Value, Growth, and Sentiment. Each of these cycles can pertain to a company, a sector/ theme, or the market as a whole.

Value Cycle

The value cycle is the swing of a company, sector, and the entire market between being inexpensive at one end, fairly valued in the middle, and expensive at the other end.

Valuation is a Fundamental-Quant concept and is calculated as a relative measure of some fundamental ratio or metric. In technical analysis, the value can be measured by comparing the price (or a price transform like RSI, MACD, Stochastic, etc.) to a time series mean (like an average, or regression).

The value cycle is useful for long-term investing. We measure valuation every quarter for both active and passive investing using the ValueScore indicator. You can follow the ValueScore indicator here.

Growth Cycle

Growth of the economy, sectors or a company happens in spurts. Spurts are periods when growth happens faster than other periods (or there may be degrowth).

To understand this better let us deconstruct a 10% annual return. The return may be made up of periods of 6% growth for 3 months, 3% growth for the next 3 months, -4% returns or degrowth for the next 3 months, and then 5% growth for the last 3 months. The net result is 10% for the year but the journey is in periods of spurts and lulls that comprise the Growth Cycle.

The Growth Cycle is useful in the medium term. We evaluate the Growth Cycle with monthly data points for passive and active investing using the GrowthMode indicator. You can follow the GrowthMode indicator here.

Sentiment Cycle

The third cycle we follow is Sentiment. The sentiment cycle also corresponds to the volatility in the market (or sector or company). When sentiment is positive (or negative) movement happens up (or down) in the short term. At other times, the sentiment may be matched by both sides. This results in volatility with a sideways movement. The Sentiment Cycle is about clarity of direction or the lack of it (not going up or down).

The sentiment is measured weekly and is useful for short-term trading. We use the SentimentMood indicator to measure active and passive sentiments. You can follow the SentimentMood indicator here.

Role of the Market Cycle

Market cycles determine the first question to be asked when constructing a portfolio.

Is it worthwhile to participate in the specific market at this point in time or not?

The Market Cycle determines the worthwhileness of the risk being taken up. If the market conditions are unfavorable, it is more likely that most positions will result in losses than wins. For a long-only portfolio, this is an important factor. It is akin to sailing a boat “with the wind” and “avoiding rough seas” when possible.

Depending on the strategy employed the corresponding Market Cycle (or a combination of them) determines whether the portfolio should be deployed or parked in a cash-like alternate asset class.

Following Market Cycles to construct portfolios gives them a tactical nature.

Tactical Management

We use asset-specific algorithms to determine whether to participate in the asset or not at a given point in time. This is reviewed on a weekly, monthly, and quarterly basis. If a specific market is not worthwhile participating in, we classify it as risk-off. The capital is diverted to a risk-on asset that (more often than not) moves complementary to the specific market.

For example, equity can be paired with gold as well as near-term debt. The combination of the tactical algorithms for each of the 3 assets gives the portfolio a dynamic asset allocation character. Weights are also assigned to different assets basis the confidence of the asset-specific algorithm’s signals.

Tactical management gives our investment strategies a market-timing characteristic.

Tactically managing a portfolio results in much lower drawdowns than typical buy & hold portfolios, with lower volatility and leading to higher Sharpe ratios.

Process-II: 3 Flags

After determining whether a market is risk-on or risk-off, the next step is to determine which securities to participate in. This is answered by the security-level principles of the QVGS Framework. The first step is to define an investment universe at an asset level to find investment opportunities.

Investment Universe

The investment universe of a strategy gives it the first set of risk-return characteristics. For example, in equity, market cap roughly corresponds to the amount of volatility that will be experienced in a portfolio. Large caps are less volatile than mid-caps which in turn are less volatile than small caps.

The size of the investment universe also determines what portfolio approach needs to be taken. Large investment universes allow a bigger more diversified portfolio, whereas smaller ones require focused portfolios.

Red Flag

Defining an investment universe does not always correspond to a viable number of securities to choose from. Therefore, there is a need to eliminate unfavorable securities not meeting certain criteria from the investable universe.

For, example in a value strategy, overpriced securities can be quickly removed. A fundamentally overvalued company or an overbought stochastic indicator is a clear rejection. Similarly, there is no point in looking for growth in poor-quality companies or stocks that have had a 90% crash from the top. (Note: We do not recommend the above or the following mentioned parameters, and use our own proprietary metrics that differ for each strategy).

Role of Red Flag

The Red Flag stage is a rejection stage. It asks the question:

What are the known bad opportunities that can be eliminated from the investable universe?

By using the principle of Poor Quality is Predictable, the Red Flag eliminates trades with a lower probability of success. This helps us achieve softer drawdowns and lower volatility in equity portfolios.

Yellow Flag

After refining the universe of securities using the Red Flag Stage the next step is to rank the remaining securities using the QVGS  principle of Cross-sectional Comparison. This is done by computing a weighted score made up of multiple criteria. For example, a growth strategy may use earnings growth from fundamental data and momentum from quantitative data and combine these to create a growth score.

Scores help rank stocks and classify them into buckets. We use separate buckets for value, growth, and sentiment cycles through our proprietary indicators. These are:

  • ValueScore Indicator – 6 buckets of Deep Discount (0) | Fair Discount (1) | Right Priced (2) | Fairly Expensive (3) | Highly Expensive (4) | Trended (5)
  • GrowthMode Indicator – 2 buckets of Expansion (1) | Contraction (0)
  • SentimentMood Indicator – 7 buckets of Extreme Greed (3) | Greed (2) | Bullish (1) | Neutral (0) | Bearish (-1) | Fear (-2) | Extreme Fear (-3)

The Yellow Flag score gives a cross-sectional view of the available universe and allows us to rank and compare the options available.

Role of Yellow Flag

The Yellow Flag is a ranking stage across the universe of investible securities. It asks the question:

Given the ideal situation which stocks would best suit the investment objective of the intended strategy (Value, Growth, or Sentiment)?

A cross-sectional view of the investible universe changes the perspective from an absolute to a relative one, allowing us to absorb information that may not be publicly available into a metric. For example, a P/E of 20 may be considered high or low in absolute terms, but the Yellow Flag stage compares the value with respect to the other opportunities available and not an arbitrary level. The stage removes the opinions and feelings of humans and makes the comparison a statistical exercise.

Green Flag

While few securities may make the top of a Yellow Flag list, it is inefficient to take a position in all of them at the same time. Therefore, the next stage is selection using the QVGS principle of Patterns.

Timing is an essential component in generating good returns as well as determining when to take up risks. Timing can be done by finding specific patterns in price and/ or price transforms using technical analysis. These patterns indicate disinterest, fear, or accumulation in a stock. Timing is also done when certain threshold values of quantitative factors are breached.

Role of Green Flag

The Green Flag is a selection stage that times the entries and exits in a specific stock. It asks the question:

Where is the active interest of the market participants focused at this point in time?

Generating better-than-market returns requires avoiding stagnation of capital. This demands constant mobility of capital towards active opportunities (and not just good potential opportunities). The Green Flag Stage is also a chequered flag for a specific stock position. It indicates when to book profits to absorb them into capital.

Process-III: Risk Management

No investment strategy is complete without the pricing of risk. Pricing risk is essential to preserving capital as well as adjusting for unknown factors. We use the portfolio-level principles of (i) 2-D diversification, (ii) Barbell Strategy, and (iii) Position Sizing to manage risk. For an equity portfolio, this is done in 2 parts.

The first part assigns a confidence score to each security basis its various fundamental, quantitative, and technical attributes that are valid for a given strategy. A confidence score between 0 to 100% translates to how much of the capital block earmarked for a single position needs to be deployed for the given security.

The second part is staggering the entry and exits of the securities. This depends on the Market Cycle. If the market is deeply undervalued, a value strategy may require the entire capital to be deployed in one go. On the other hand, in a fairly priced market, it would make sense to deploy capital in blocks of 20% over 5 data point periods. Staggering capital deployment mitigates the chances of loss from a bad signal (a whipsaw).

Role of Risk Management

Successful investing is about keeping in mind that there will always be another opportunity tomorrow or another day. The Risk-management stage intends to take appropriate exposure at a given point in time depending on the market conditions as well as the stock-specific conditions. It is a position-sizing process that asks the question:

How much of the total capital is worth risking to gain from the opportunities now?

Putting it Together

At Modulor Capital we create and manage Quantamental equity portfolios with the 3 processes Process of:

  1. Tactical management,
  2. 3 Flags, and
  3. Risk management.

The processes are run recursively by choosing the appropriate Market Cycles, using different methods to reject, rank, and select stocks, and factoring in the price of risk. The diagram below illustrates the process.

How to invest Quantamental?

To invest in portfolios made using Quantamental Investing start a one-on-one Conversation here.

About Us:

Modulor Advisory Services is a Securities and Exchange Board of India (SEBI) Registered Investment Adviser (RIA) with license number INA100015115.