[smabie]

The most popular kind of quant trading is using a factor model. The first step is developing some alpha factor, a number that is predictive of how much money you'll make from each stock. So let's say my alpha factor is "companies with good earnings per share will go up." So I first take the EPS for all the stocks in my universe and maybe rank, then zscore. Now I have some positive numbers and some negative numbers. These represent the weights of my portfolio. The positive weighted companies I go long, the negative ones I go short. The bigger the number, the larger my allocations.

Now that I have my alpha factor I backtest it and whatever. Since the mean of a zscore is zero, I know I'm market neutral, so (ignoring some stuff) my factor should have little exposure to the market.

If I think it's good, I add it to my other alpha factors and combine them somehow. Could be as simple as adding them all up, or maybe something like using random forests to figure out the best way to combine them, or whatever. Now that I have a bunch of alpha factors all combined, I can run them through the optimization engine.

The optimization engine will adjust the weights of my "ideal" portfolio in order to reduce exposure to various risk factors (thus lowering volatility). My optimizer will also figure out how often I need to rebalance. There's generally a bunch of terms in there that try to reduce trading costs and zero out exposure while not diluting the "ideal" portfolio too much (or else the alpha could be wiped out).

Now, after all of this, I'm ready to trade.

In short, what we're trying to do is reduce our exposure to as many factors as possible and just get exposure to our alpha factor. We don't want the market, price of oil, sex scandal of a CEO, or anything else affecting our portfolio. We are trying to dig up this latent, unearthed, alpha that exists in the market, but doesn't belong to one company or asset.

[steephills]

Taking EPS as proxy for alpha is like trying to recognise banana pictures by looking at average yellow content: it is plausible, but roughly 100 years behind the other market participants. Don't do this kind of stuff with your hard earned money...

[DSingularity]

He was using that as a simple example.

[steephills]

Yes, I just wanted to make a point: things that have names, that have a paper written about them, that have Wikipedia pages or even Nobel prices attached to them are in the same category. The market has priced them in decades ago.

Thinking you can read Fama papers to take on quant funds, like smabie is claiming at several places in this thread, is like reading Commodore manuals to take on AlphaGo.

[perl4ever]

I feel like I've read something recently about how there's evidence people don't actually read SEC filings.

It's kind of like the theory that open source doesn't have serious bugs because so many people read it.

You know the saying that the market can remain irrational longer than you can remain solvent? If some people don't care about doing simple analysis, and others assume that someone else is doing it, and still others accept that it's useless to do it if other people aren't, it seems like a none-too-efficient market can be a stable equilibrium.

[bobbiechen]

Similarly, the book The Big Short (Michael Lewis) notes that hedge fund manager Michael Burry read hundreds of prospectuses for mortgage bonds in the years leading up to 2008 and was "certain even then [in 2005] (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them." He ended up shorting these and profiting hundreds of millions of dollars.

[smabie]

From my analysis, there's around a 3.9% abnormal return associated with a L/S beta neutral low beta strategy (long low beta, short high beta). It's Sharpe ratio is ~1, though. 3.9% is pretty significant, especially since the beta correlation is less than 2%.

There's a reason why these factors are called "persistent." For systemic reasons, it is hard to arbitrage them away, mostly due to laws, and sometimes tax implications.

[AlexCoventry]

That's the ideal described in quantopian tutorials, but I doubt it often works out that way.

[smabie]

From personal experience, it really does actually work that way. Not all quant firms are running traditional market neutral factor portfolios though.

[AlexCoventry]

How much money have you personally made with this approach?

[smabie]

Market neutral strategies really only work with significant access to leverage and favorable financing. Retail investors such as myself are unable to get the kind of juice necessary to run a L/S market neutral strat.

Of course, I suppose it would be possible if you discovered some amazing alpha factor. But if you did, you probably would be better just trying to get investors.

So in short, the answer is $0. For my personal portfolio, I run (only started recently) a variable leveraged beta strategy that can be described in my three part series:

https://cryptm.org/posts/2019/10/04/vol.html

https://cryptm.org/posts/2020/05/28/vol2.html

https://cryptm.org/posts/2020/06/09/vol3.html

[AlexCoventry]

Thanks, looks interesting.

[steephills]

Really? So you're saying, not all $10tn of quant funds in the US market are managed in the way you just described?