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Quantitative investing part 2: Designing a strategy

In our previous column on quantitative investing, we introduced four basic elements - design, test, optimise and evaluate. We will now explain design, the first element.

This primary element means designing an investment strategy by looking at idea generation, set-ups, entry and exit, stop, position sizing or money management, and portfolio construction.

We will now elaborate on the first two.

Idea generation, as applicable to investment strategy, is the designing or defining of the guidelines of a given investment model.

Say Mr A is a value investor seeking to apply a quantitative investment tool to support his investment. He may set his investment model guidelines by focusing on fundamental and value factors like investment in high return on equity (ROE) with stocks with low price-to-earnings (P/E) ratios.

The variables for idea generation in the investment guidelines fall into three groups:

l Technical factors, such as trend following, mean reversion, spread trading, swing trading and band trading;

l Fundamentals, such as growth, quality/stability, profitability, cash flow and yield/value;

l Others, such as economic factors, sentiment, volatility, analyst consensus and market anomalies.

Since we can combine many factors among groups, these variables may be based on a single or multiple groups.

"Set-ups" is a set of conditions that must be fulfilled before one starts investing or trading. One can apply technical or fundamental variables, as in idea generation, or mix all the variables together to create new conditions for set-ups.

"Set-ups" is a filter before stock trading to enhance opportunities to make profits, reduce investment risk or invest in line with an investment policy and investor characteristics.

Here are some sample set-ups for sound investment conditions:

Overall market set-ups

l Market P/E must be lower than 15 times

l Current index level must exceed 200-day exponential moving average

l Market volatility must be lower than 25 per cent

l Average daily turnover in one month must exceed Bt30 billion

Individual securities set-ups

l Avoid stocks with average turnover below Bt20 million

l Stock market value must exceed Bt3 billion

l Stocks' three-year average ROE must exceed 12 per cent

l Avoid stocks with volatility higher than 40 per cent

l Other set-ups, such as seasonality

l Do not buy stocks on Friday for selling on Monday

l Do not buy stocks in May because of the "sell-in-May effect"

The ideal "set-up" conditions are in line with your beliefs or investment philosophy, while managing investment risk and investment capital. In our next column, we will deal with the four minor details of set-ups - entry and exit, stop, position sizing and portfolio construction.

Asset Plus Fund Management contributed this article


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