Equity investment also known as shareholder’s equity is the amount of money that shareholders would receive if a company liquidates all its assets and clears debts. Equity is a financial metric used by financial analysists to assess and measure the financial stability of a company. Equity investments of a company are highlighted in the balance sheet to represent the degree of ownership. The shareholders’ equity is obtained through subtracting a company’s total liabilities from the total assets. There are different types of equity investments in a company with the most common equity being stock. Stock in a firm represents the ownership interest of a shareholder hence identified as private equity. Private equity contributes to capital gain for the shareholders and dividends (Harris, Jenkinson, and Kaplan, 2014). The shareholders have voting rights hence active participation in the company’s decision-making process. This paper takes a major focus on a blueprint for a factor-based long-short US equity investment that can be traded in the Australian market.
Factor-based equity investment
Factor-based equity investment is a form of strategic investments that selects securities and stock based on the amount of return associated with the investment. The strategies utilized to ensure that high returns are obtained and risks associated with the investments are managed. Factor investing enhances diversification in equity investments by active investments across different shares (Pappas, & Dickson, 2015). High returns on investment are influenced by two factors which include the style factors and the macroeconomic factors. The factors aim at spreading risks across different assets and also explaining the returns and risks associated with different investments. Factor-based investing promotes portfolio diversification by targeting persistent, broad and popular stocks that offer high returns. There is a range of factors to consider in factor investing which makes the strategies overwhelming. However, there are simpler elements to incorporate in identifying the attributes of securities. The simpler attributes include risk, size, and style of equity.
Factor investing focuses on attributes such as value which aims at capturing high returns from stocks whose prices are low compared to their fundamental value (Dimson, Marsh, and Staunton, 2017). The value of equity can be tracked through dividends, price of earnings, price to book and the free flow of cash. The size of a portfolio matters with small-cap stocks being associated with high earning compared to large-cap stocks. The size of equity can be identified through market capitalization of equity. Investors are advised to study the momentum of stock to identify the stock performance in the previous period. Previous and current high performance of stock projects increased returns in the future. The quality of a portfolio is important as it affects returns. An effective portfolio has low debts, consistent asset growth, stable earnings, and its corporate governance is strong. The volatility of stocks is an attribute that should be highly considered because rapid and unexpected changes affect the rate of returns negatively (Alberg, and Lipton, 2017.). Stocks with low volatility are a preferable investment as they are associated with minimal risks.
A profitable U.S equity investment that can generate high income for the Australian market is the Apple products. Apple has been known to be a technology giant globally and among the best companies in the world (Browning, Russolillo, and Vascellaro, 2012). There is a high demand for Apple products and also the company has a large customer base. Apple makes up 45% of the U.S smartphone market and generates 60% more revenue than its closest competitor which is Samsung. Apple is a reputable organization that has been attracted to brand loyalty from customers due to the production of modern and high-quality mobile phones. Investing in Apple Inc is a productive equity investment as there are high earnings obtained (Mallin, and Finkle, 2011). Currently, the share price of Apple Inc equity is $189 thus more profits for the shareholders.
Backtesting process
The Australian stock market is very competitive and has risen in the current months to its initial earnings. Since 2007 the stock market in Australia has been decreasing continuously contributing to looses and low returns among shareholders. In order to select the best performing U.S equity investment that will promote the Australian market backtesting is necessary. Backtesting is a vital trading and investing strategy that enhances the process of testing and measuring trading hypothesis in previous instances (Campbell, 2005). Investors are encouraged to utilize backtesting as it is equipped with relevant information from the past. The back-testing process enables investors to gather information on the performance of the stock, the information is then analyzed and summarized to provide information on the profitability of equity and risks associated. From the points given an investor can make profitable decisions by selecting the most favorable portfolio. Backtesting in many cases offers high returns for investors (Ni, J. and Zhang, 2005). Backtesting is applied to investment options that are quantifiable. Essentially backtesting explains that any strategy implemented in trading and yield returns is likely to yield better earnings in the future.
The testing process of equity can be implemented both manually or automatically. Automated backtesting is implemented through the use of codes developed by the user to suit the user’s strategy. On the other hand, manual backtesting is done through the studying charts and associated conditions manually then placing the stocks according to the investor’s rules. Manual backtesting is more effective because an investor can incorporate current market conditions that keep on changing in making the investment decision (Barone‐Adesi, Giannopoulos, and Vosper, 2002). The back-testing strategy takes into considerations factors which include risks, profits and time in selecting an investment product and market. The assets and markets are the main elements that high contribution to the rate of return. Apple Inc portfolio is opportune investment equity which trades in the technology market that is highly profitable.
The consideration of the stock prices is a vulnerable factor in investing. An investor should be equipped with a large pool of information. From the information, the investor is able to identify the price fluctuation trend of the shares in relation to market conditions provided. The share prices of Apple stock have been noted to increase since the company was founded. A common market condition that affects share prices includes monetary policies, annual reports of the company performance and inflation rates. Testing and studying market conditions equip an investor with knowledge of how a particular portfolio will perform under certain conditions (Strong, 2008). Effectiveness of backtesting strategies can be identified through gauging the strategy against benchmark parameters. Key parameters include success ratio, dollar p/l, and the Sharpe ratio.
The implementation of backtesting can be carried out through various methods such as the utilization of platforms and used of simulators (Campbell, 2005). The testing of market simulators is important because the process highlights various problems encountered in executing the testing strategy. Simulators can be used in many market conditions hence offers extensive market information. Main platforms used in backtesting include trade station which offers an electronic order that is execution across many asset classes. Traders are allowed to carry out their trading from live P&L charts that offer portfolio management (Fabozzi, and Markowitz, 2011). Trade station utilizes simple terms that an investor can use to create charts and establish algorithmic trading strategies. Another useful platform is the ninja trader that offers advanced backtesting strategies, charting and trade simulation. There is a comprehensive trading platform which incorporates strategy development known as the quanta blueshift. The platform provides data that is integrated and of high quality. Quanta blueshift utilizes cloud-based elements in the testing of markets and developing pf trading strategies. Portfolios can be optimized and analyzed through the Amibroker platform. The platform has various technical indicators which highlight vital aspects of a portfolio.
Trading systems are evaluated through parameter provided by backtesting. A major parameter is a total profit or loss that an investment is likely to make. The total R/L helps in determining the relevance of a trading strategy. Investors gain more understanding on the effectiveness of the strategies based on historical information that has been tested. The average P/L is a parameter that indicates the losses or profits that an investment is likely to attract over a specific period. Another parameter is the success ratio that illustrates the number of times a trader has benefited and made a profit from using factor-based strategies. The parameter also illustrates the effectiveness of current strategies together with recommending areas that require updates and optimization with the aim of maximizing benefits. The Sharpe ratio parameter calculates the risk-adjusted return. The Sharpe ratio entails various strategies that are likely to offer an investor a similar return. The investor has a range of options to select from with the strategy that attracts lower risk being the most favorable option.
Backtesting of factor-based investing
The testing of factors that affect a particular portfolio is conducted to provide investors with information relevant in their decision-making process. An investor can test the value of a portfolio based on its past performance. Apple Inc. portfolio has a high and reputable performance with its share price index increasing throughout the years. Through backtesting, the investors are able to identify whether the stocks make profits or losses (Ni, J. and Zhang, 2005). If the stocks have been identified to have continuous high earning the stocks are too projected to perform better in the future. The investor has the ability to identify market conditions that contribute to the high returns of the stocks. With the knowledge of the market condition, the investor implements strategies associated with high returns and avoids conditions that attract risk together with negative results. A market condition that favors Apple Inc is the advancement of modern technology.
The volatility of the portfolio should be tested in factor-based investing. Investigation on how the portfolio reacted to change is an effective strategy (Alberg, and Lipton, 2017). Factor-based investing is very unpredictable because the factors influencing return can change anytime. A profitable portfolio should be flexible in that it adapts to changes and does not attract negative results. An example, a portfolio should not be affected by money policies by complying with all outlined trading rules and regulation. Although mitigation of negative results brought about by volatility can be reduced hence fewer losses identified. Presentation of averages is important in factor-based investing. Previous average gain, losses, and bars can be analyzed to obtain the trend of the stock. A consistent trend in gain illustrates the profitability and stability of a particular trend hence investors are able to make profitable investment decisions.
Backtesting of factor-based investing highlights the percentage of equity exposure to the market. From gathered historical data an investor can identify the total capital that has been invested in a particular portfolio. The investor is enlightened on the total capital that is exposed to risks such as losses if the market conditions and other factors do not favor the stock. The investor is able to make a decision on whether to risk investing in the portfolio or not. Factor-based investing obtains various ratios from backtesting. The ratios identify highlight the ratios of gains against losses. If the gains ratios are high the investor is advised on investing in the portfolio while high ratios of losses illustrate inefficiency of the investment. Factor-based invested can be tested through the annualized rate of return. Investors are encouraged to review the annual returns of a portfolio in the previous year before making the decision to invest. Portfolios with high income and profits over the previous years are great investment options. In other instances, backtesting provides a risk-adjusted return. The adjusted return illustrates the potential number of risks that a portfolio encounters in the prior period. The return also shows the risks that affected the portfolio and the losses that’s were experienced. Investors prefer a portfolio with minimum risks as it easy to mitigate and fewer losses are encountered.
Selected factors
Backtesting strategies in factor-based investing are carried out over a long period of time. The time period shows the trends of a portfolio in relation to different surrounding factors and scenarios. The strategies are controlled by market conditions which are subjected to change hence data on trends under different conditions are relevant. Factors should be tested over a large universe which consists of different markets, time zone, seasons, products, innovations and population (Virdi, 2011). The testing on the universe elements is important because the portfolio can be traded across different dimensions. Backtesting keeps volatility low in order to ensure that an investor does not trade in a very risky market that can attract losses. An investor is advised to trade in low volatile portfolios which are associated with minimal risks and high returns.
The level of exposure of a portfolio is an important element in backtesting. Exposure in investing has both negative and positive impacts. A portfolio with high exposure may lead to high profits or extensive losses depending on surrounding market conditions. Decrease exposure ensures that the portfolio is safe but contributes to lower return. The level of exposure should be a little bit on the high levels to ensure that there are high returns obtained and the risk may or may not happen. Traders use backtesting to determine the optimal position, size, and management of money. Investors are able to take up relevant positions in a large and profitable portfolio which also helps them in managing the earnings. Backtesting enables factor-based investors to customize their data. The investor is able to analyze and use data to suit their needs. Customization of backtesting offers accurate information that is highly utilized in trading. Backtesting is faced with challenges of over optimization where investors highly rely on previous information that is ineffective in the future due to changes in the market and conditions (Acerbi, and Szekely, 2014). The strategies are inaccurate in some cases because the past factors differ from future factors.
Multi-factor model
A multi-factor model is a model utilized in the financial sector to illustrate how multi-factors are incorporated in the calculation that explain assets prices and market phenomena (Asl, and Etula, 2012). The model is used in carrying out a comparison of two factors affecting a portfolio. The factor-based investing compares the macroeconomic factors and the style factors to illustrate the performance and variables of a portfolio. The construction of portfolios is carried out through methods such as combinational, sequential and intersectional modeling. There are three categories of multi-factor models which include a macroeconomic model that compares the returns of stocks in relation to factors such as interest, inflation, and employment. The fundamental model offers an analysis of the relationship between portfolio earnings and other underlying financials of the portfolio. The other model is the statistical model which compares the returns of different securities by using statistical information.
The multi-factor model is constructed through a combination model which utilizes a single factor in distinguishing stocks. The factors are later combined to form the attributes of a stock hence forming a multi-factor model. The other model is the sequential model that arranges the factors of stock in a precise sequential manner (Bender, et al 2013). The various factors form a multi-factor model that incorporates different elements. The intersections model sorts out stock in relation to their intersections for different factors the most common intersectional factors are momentum and value. The three construction methods are all relevant in factor-based investing. U.S equity investment is affected by factors such as value, momentum, and profitability.
Composition of factors
The factors can be constructed through the combination model that combines the two main factors utilized in investing that is value and momentum (Asness, et al, 2014). The equity investment in the United States is mainly influenced by low volatility and value. Low volatility and value are utilized in factor-based investment to increase earning in the fixed income portfolio. Australian investors are encouraged to engage in U.S equity that is very risky because the investment has high returns. There are few investors who engage in risky investments as they fear to encounter losses. From the back testing of U.S equity, risky investments because they yield high returns. The most preferred investment option is exchange-traded funds. The ETF in the United States has great value in that the assets have low prices but they have as high fundamental value.
Value in the ETF portfolios has issues that are inherited from previous periods. Portfolios that greatly rely on value are very expensive and unpredictable. Many value investors have encountered losses hence opt to combine the value factor with momentum (Asness, et al, 2014). Stocks associated with momentum rise quickly and are cheap. The value and momentum can be initiated in a portfolio through the three multi-factor model categories. The portfolios with value and momentum contain a similar number of stocks thus there are ranked in both the top and bottom percentages of the universal stocks. The factors in the U.S offer diversification of stock which increases the rate of return. Through the combination model, the value and momentum factors are created separately and then combined to form a correlation. The combination has a negative correlation because the two factors have conflicting positions.
The two factors can be constructed through the sequential model where the investor ranks the factors by giving the most important factor priority (Bender, et al 2013). The sequential model is unique because the stocks decrease after every ranking. The shrinking of the universe stocks results in a more concentrated portfolio that has higher earnings. In the arrangement, the two factors seem to be identical as they pose returns that are slightly similar. The sequential model ensures that both factors provide similar results hence there are no diverse negative effects obtained. The two factors can be compared through the performance of the portfolio in the intersectional model. The intersectional model depends on the observation of portfolio performance.
Momentum in factor-based investing entails the assets that have established high performance in the past. The momentum of the equity can be measured by comparing the returns obtained and the returns in previous years. Volatility is a factor that affects the returns of stocks thus fueling the momentum of stock prices (Clarke, De Silva, and Thorley, 2016). The changes experienced in the market conditions together with unpredictable factors increase the risk and returns of a portfolio. Assets that have low volatility maintain a constant trend which is associated with minimal risks and high earnings. The low volatility increases the confidence of investors in investing in a particular stock and influences the profitability of stock. The quality of a portfolio is relevant to an investor as quality attracts high prices. The quality of a portfolio can be measured through stability in returns, the growth of dividends, the strength of the balance sheet and also an efficient management system.
The backtesting of momentum and value of equity investment in the U.S is evident through a selection of portfolios with great valuation and its share prices have an increasing trend. From backtesting results investing in low valuation stock is cheap as the investors anticipate the value to grow with time. The example previously technology had a low valuation and currently it yields the most earnings due to innovation. The innovations and advancement in technology are leading to high momentum as the share is in high demand. Investors are encouraged to obtain workable ideas which are based on trading rules. The ideas are supported by discipline in following the rules that lead to investment in profitable portfolios.
Momentum can be tested through the fluctuation of prices. The fluctuation of portfolio prices has different correlation hence instruments such as level of liquidity indicates the different segments of stocks in a market. Portfolios that have high value have been observed to have high earnings in the past. Backtesting of momentum and value of a portfolio is hindered by issues associated with logic and the occurrence of single events (Giamouridis, and Vrontos, 2007). Some traders explain that the factors do not highlight the effects and causes of momentum hence momentum is not robust. Value and momentum factors are less effective because strategies based on the factors were utilized in scenarios that had different market conditions.
Long-Short portfolio
Long-Short portfolio provides an investing strategy where an investor takes a long position in shares whose prices are expected to increase and secures a short position in a portfolio that may decline. The long short portfolio strategy seeks to minimize the market exposure of stocks thus reducing risks and losses. The long position in the portfolio increases the returns of stocks while the short position decreases the prices of the portfolio. The strategy is common among hedge funds where traders utilize the neutral strategy (Hoesli, Lizieri, and MacGregor, 2008). The long short portfolio strategies are differentiated through market geography, sector and investment philosophy. A major portfolio that can generate high-income stocks is the technology industry. The technology industry is very productive and competitive with it having a high valuation due to innovation. The value of technological products increases momentum in prices hence more income. Regular investors are allowed by ETFs to build their own hedge portfolio as there is a big divergence in between the top sectors and bottom sectors of industry.
ETFs provides a cheaper initiative in creating a long-short portfolio compared to the construction carried out by managers. Hedge funds provide a profit of 20% annually while the assets are charged at 2%. Using EFTs in creating an individual portfolio is important because the process does not have a trading fee and it is tax efficient. The creation of long-short portfolio offers an investor the opportunity to realize capital gains which offsets losses incurred (Hoesli, and MacGregor, 2014). Investors believe in the long run results of a stock that is the increase in index fund hence taking the long-short portfolios. Investors invest most of their funds in long positions as there will be higher returns and a lower percentage is invested in a short position where the portfolio generates income quickly but the earnings are low.
The long-short portfolio is important because the strategy reduces the risk that may affect the market. The strategy ensures that an investment does not attract any losses and the risks are eliminated thus making the portfolio safe. The long short portfolio arbitrages the expense ratios presence in the Exchange Trading Funds. The strategy reduces investment costs because an investor has lower expense fund and the higher expense funds are shortened (Blundell, and Ward, 1987). The portfolios are tax efficient because the selling of a certain portion of stocks in an appreciating market generates more gain and the taxes deducted are lower. The transaction is compared to holding on to a portfolio that is charged several times, attracting high taxes.
The portfolio has been termed to be ineffective as the stocks are not completely hedged (Giamouridis, and Vrontos, 2007). In case a market goes down various sectors also fall down leading to losses, risks and low earning. Portfolio investments can be worse compared to having money in cash form. In case the portfolio performs poorly in the market an investor is likely to lose. The losses increase due to the long positions that are of high amounts and is highly exposed thus attracting more risks. Short positioning of the portfolio does not generate interest in the investor’s money. The positioning does not generate interest if the stock momentum is constant due to the shorted ETFs sectors. Another limitation of the long-short portfolio is that it is tax inefficient. If the gains earned from long positioning are limited an investor is likely to make losses or obtain low gaining as the portfolio is subject to taxes over a long period.
Performance analysis
Technology shares in the mobile company are a great investment as the shares have high valuation and momentum. Mobile phones utilize technologies that are created and advanced from time to time. The advancements increase the value of a phone hence an increase in the share prices. Innovations incorporated on phones are mere ideas or illustration that have low meaning before their implementation. The ideas are mainly found amount employees which entails that they are easy to obtain. The long short mobile phone portfolio reduces the investors’ exposure to the market. An investor is able to gain returns in a down market which is the sales of gadgets. The portfolio generates more income in the technology market where consumers seek the most advanced and modern technology thus paying more for mobile phones. The portfolio generates income through the arbitraging of expense ratios and also the stocks are tax efficient if there are no unrealized gains on capital. The strategies are not taxed efficiently when the mobile market falls because the unrealized capital gains are moderate thus leading to more losses. The long short portfolio requires large unrealized capital gain that is associated with high risks and high returns.
