Every portfolio manager has a different idea about how markets work which makes them follow an investment process that is uniquely suited to how they think. This thinking is an outcome of the experiences of the portfolio manager in the markets, resulting in an infinite number of ways to construct a portfolio. Yet, when constructing and managing portfolios some principles hold true across all styles of investing and are a part of every investment process.
At Modulor Capital, we have identified a few key sets of investment principles that have stood the test of time. These principles come from different schools of investment analysis – fundamental, quantitative, and technical. Together these principles form a framework (not a model!) that is open to evolution as our understanding of markets and investing grows. We call it the QVGS Framework, (Quantamental Value Growth Sentiment).
The QVGS Framework classifies investment principles into 3 levels that hold across asset classes, geographies, and timeframes:
- Market-level for managing assets
- Portfolio-level for containing risks, and
- Security-level for generating performance.
These principles are a condensation of our understanding of investing. Flowing through this cascade of principles allows us to create and maintain a sound portfolio. We follow them rigorously.
Market-level Principles – For Managing Assets
Markets are random in nature. It is difficult to describe what is happening in the market at a point in time with precision. However, the market does follow some predictable rules. Understanding these rules prepares us for the unexpected.
Using Market-level principles, we intend to manage assets by:
- Moving with their cycles,
- Keeping forecasts realistic, and
- Pairing assets to avoid volatility and generate smoother return curves.
The market moves in a cyclical fashion. However, this cycle is neither predictable regarding time nor can its magnitude be determined with precision.
While a classic (and simple) description of market cycles presents it as boom, doom, and gloom of bull and bear markets, in reality, the market cycle is an overlap of many cycles operating in different timeframes.
We have identified three timeframes that are relevant for investing.
- The long-term cycle is relevant to timeframes of 10 years and beyond. Every once in a while but once in 10 years the market goes on a firesale where good assets are available at deep discounts. We call this the Value cycle.
- The medium-term cycle is called Growth and happens at least once in 5 years. The Growth cycle represents a genuine appreciation of assets as human beings create and enhance the value of the economic system. Each Growth, cycle is a lottery, wherein a different set of sectors and industries lead the market.
- In the short term, the Sentiment cycle influences the market. At least once every 3 years the market gets cornered by buyers or sellers based on the strength of their beliefs and the willingness to act upon them.
Investing is based on being rightly able to identify what is likely to happen in the near to far future and acting on it. While predictions are necessary to take relevant positions, the limitation of their accuracy also needs to be considered. In general, the further into a future a prediction is, the lesser its likelihood of coming to fruition.
Longer-time predictions have lower accuracy because of the more number of things that can happen between now and the predicted future that can alter the eventual outcome in the future.
We keep our forecast windows limited to 1-week, 1-month, and 1-quarter and link them to short-term (sentiment), medium-term (growth), and long-term (value) cycles respectively. This requires us to review and adjust our forecasts periodically in order to avoid catastrophic outcomes.
While Market Cycles are predictable, they cannot be timed exactly. However, they can be tracked with fair consistency with some room for errors.
The market pays what it pays in a given period of time for a given cycle. Investors cannot change that.
A major component of outperforming the markets comes from avoiding negative periods.
In negative periods, assets either give negative returns or move with high volatility. Both scenarios are not desirable by investors since in the first case it is painful to give back the gains and in the second case investors are mentally fatigued.
During negative times there is always an Alternate Asset that may provide lesser but positive returns and takes away the fatigue. An Alternate Asset moves complimentary to the primary return-generating asset. For example, when equity is not likely to perform gold or debt may be better alternatives.
Alternate Assets are a store of value and can be in the form of cash, debt, gold, or equivalents. While alternate assets do give positive returns, their primary job is not to generate large amounts of returns. Instead, their job is to keep funds available to deploy when required. For this reason, alternate assets need to be highly liquid.
Portfolio-level Principles – For Managing Risk
Safety saves when investing. No matter how well-designed a strategy is or how high the success probability of an analysis is, there can always be an unfavorable investment outcome.
We understand that bad outcomes are commonplace in investing despite making good decisions.
Such outcomes cannot be controlled by better analysis or design (since markets are random in nature) but can be managed using portfolio-level principles.
At the portfolio level, we intend to manage risk by:
- Diversifying it within and across assets,
- Balancing it through selective exposure, and
- Pricing it.
Diversification is a well-research strategy for investing. Essential diversification says that a portfolio needs to be invested in 20 to 30 stocks to ensure that the security risk is mitigated. This is an excellent point to start with.
However, for us, diversification needs to be done not only within an asset class (like equities) but also between asset classes in order to get a (near) bullet-proof possibility of a good investing outcome. We follow 2 dimensions when diversifying over the long, medium, and short term:
- Inter-asset diversification is useful when constructing long-term portfolios. Assets move complementary to each other in longer timeframes where one asset may outperform the other for limited periods of time (depending on the larger economic) conditions. Dynamic Asset Allocation is a tool that enhances the effect of inter-asset diversification.
- Intra-asset diversification is useful to overcome the idiosyncrasies within the asset class. This is different for each asset class. Apart from the typical diversification ideas of market cap, sectors/ industries, duration, quality, and specialization, we also diversify between investment styles and investment timeframes.
Risk needs to be balanced. The average of low and high-risk yields better investing outcomes than simply taking up middling risks. The lower risk component provides lower returns but also provides the preservation of capital. Whereas, the higher risk component is volatile but also provides the possibility of outsized returns. Together the same return can be achieved with lower volatility using an appropriate weighted average than a single middle-risk middle-return asset.
Taking up extreme risks (and omitting middling risks) is called a Barbell Strategy.
Barbells can be created between asset classes as well as within asset classes. Fixing the proportions of risks is useful when using a buy-and-hold strategy. This is a Strategic Barbell where the proportion of high and low-risk are optimized. A classic example is a portfolio holding 60% equity and 40% debt.
Barbells can also be made in another way – a Tactical Barbell. A Tactical Barbell holds 100% equity 60% of the time and 100% Debt 40% of the time. The result is higher returns and lower downside volatility than a classic Strategic Barbell.
At Modulor Capital, we tactically manage growth or accumulation-based assets (like equity or gold) and barbell them with debt or equivalents. This allows us to lower exposure to downside volatility and gain from upside volatility to generate better risk-returns characteristics. Tactical barbells are linked to market cycles and Alternate Asset pairs.
The final aspect of managing risks is to price them. There are no 100% winner calls in an investment strategy.
Each profitable investment strategy must satisfy an equation where the number of winners multiplied by the average size of a winning position is larger than the number of losers multiplied by the average size of a losing position.
To further reduce the impact of losers, a confidence level can be ascribed to each investment call within the portfolio. In order to apply this confidence level to trades, we size the position of each trade between 0 to 100%.
Position size is the percentage of utilization of the capital block allocated to the trade. For example, a portfolio with 10 stocks will start with 10 blocks each of 10% capital. Position sizing will determine how much of this 10% block is used. If the confidence is 100%, then the complete 10% will be used. However, if the confidence is lower say 65%, then the resulting utilization will be 6.5% of the total capital for the trade.
The balance of unutilized capital can be kept as cash, deployed to the alternate asset, or can also be used to create additional capital blocks (taking the number of positions beyond the original 10). Different options are suitable for different market conditions, investment timeframes, and investment styles. For example, volatile markets may direct lesser exposure to be taken which is influenced by position sizing. The spare capital can be parked as cash if the Alternate Asset is not attractive or deployed in the Alternate Asset. Many different scenarios can play out and actions need to be pre-determined by the strategy.
Security-level Principles – For Generating Returns
Generating returns is considered a highly valued skill. There is a lot of talk about skillful investment managers who pick winners. Yet there are few investment managers who have consistently picked a high percentage of winners.
Professional managers understand that losing trades are also a part of the investment game.
We go a step further by not trying to pick winners but working hard to reduce the number & magnitude of losers. This ensures that our surprises are positive and that bad opportunities are removed.
At the security level, we intend to generate returns by:
- Eliminating large losers,
- Comparing a large universe, and
- Time trades using specific predictable patterns.
Poor Quality is Predictable
Losing trades are part of an investment strategy. The shorter the timeframe the lower the number of winners (which is compensated by more trades that raise the average value of the winner). However, in each timeframe extremely bad winners can be avoided.
There are always poor-quality trades that can be easily eliminated by looking at simple parameters across fundamental and quantitative criteria.
It is easier to avoid poor quality by rejection than to predict winners by selection.
Removing these trades from the distribution of trades improves the overall characteristics of an investment strategy, thereby making capital more efficient and protecting the investor’s psyche.
Poor quality can be identified by using simple filters on fundamental, quantitative, and technical data. However, care must be taken to define exception scenarios when designing elimination filters to balance between positive and false positives. For example, perpetual high debt (leverage) is an indicator of weakness but not if the company is in the capital expenditure stage.
Factors are a great way to rank stocks. Different factors work well in different timeframes and are suitable for different styles of investment. Yet, there isn’t any one factor that alone predicts the outcome of a stock. Multiple factors come into play at a given point in time. This requires us to develop a composite score of factors for a given strategy where different factors hold varying weights depending on the investment style of the strategy.
Since factors are computed using machines, a large amount of data can be processed. The net result is a composite score that produces a ranked list. The top quartile, pentile, or decile of the ranked list then becomes a high-probability universe to invest in for good outcomes.
Composite scores are a great way to objectively compare securities that may belong to a sector, industry, a specifically targeted universe (like a market cap), or even an investment style (like value, growth, etc.). It is also used to compare sectors and even economies across the globe.
While typical quantitative investing would buy the entire top quartile, pentile, or decile of a ranked list, we are able to target specific securities that are more likely to perform sooner than others using specific patterns.
Repetitive patterns are observed in price, price transforms, and other trading / non-trading data. In trading data patterns are formed because despite all analysis investors can do only 2 things in the market – swell or buy. The actions of selling and buying are linked to human behavior and form patterns when these actions are executed. Patterns have varying degrees of accuracy and are more useful during specific market conditions or hold more weight during certain events.
Patterns to buy or sell provide a timing component to the entry and exit of securities.
This ensures that capital is always working and that return-dropping stagnation is avoided.
Converting principles to processes
Together the market-level, portfolio-level, and security-level principles form the QVGS Framework to invest and maintain multiple portfolios following different investment philosophies. In order to implement the principles of the framework we have set them into 3 processes that are run like clockwork on a weekly, monthly, and quarterly basis. These are:
- Tactical Management Process – to time the market and vary exposure to assets.
- 3 Flag Process – to reject, rank, and select securities and time their entries and exit.
- Risk Management Process – to keep room for error and benefit from volatility.
How to invest Quantamental?
Modulor Advisory Services is a Securities and Exchange Board of India (SEBI) Registered Investment Adviser (RIA) with license number INA100015115.