Using a Regime Filter

A regime filter or a market regime filter is a tool to help us conceptually understand the kind of market we are in. As a systematic investor, we can increase our odds of success by adding a regime filter to our arsenal. It tells us, based on how we have defined it if we are in a bull market or a bear market. We would think differently about market risk in different market scenarios.

A simple example of a regime filter is using the 200 day moving average. If the index of your choice is above the 200 day moving average, then you define it as a bull market and below it as a bear market. You can design your portfolio strategy to hold full allocations in stocks if you are in a bull market and 50% allocated in a bear market.
So, with that basic logic you can start constructing a slightly more realistic and slightly more nuanced regime filter.

First, define the market conditions you want to address – superbull, bull, bear, superbear. The reason for doing that is you want to be cautious in the market extremes of superbear and superbull conditions and aggressive in the bear and bull conditions (for long-short strategies). Then use a combination of indicators like RSI and 50 & 200 day moving average to define the selected conditions. For example, above 200 dma and 70 RSI you define as superbull and above 200 dma and above 50 RSI as bull phase.

Another trick that can be used is to use multiple indices. For example, you can use the average of Nifty, Nifty Next 50 and Nifty 500 in equal proportions to define your market. For a long-only investor, it may increase the odds of success to be buyer only when the regime filter is indicating a bull market.

Note: For exploring quantitative systems, check out www.quantamental.in, a quant-based newsletter. 

Book Review: What Works on Wall Street

Since I started investing in 2000, I have read literally thousands of books related to investing, business, biographies, history, behavioural psychology and economics. I have written about a few books on my blog before. Recently, a very close friend asked me to suggest to him a list of 52 books that he would read one a week. In my endeavour to pick some great books across genres, I thought I will start posting book reviews from my notes of some of the books I read, liked and disliked over the years. 

I also intend to add a page to this blog for a ready list of the books. If anyone has any great books they have read and loved, please let me know the name and why you loved it and I will try to add it to my reading list. Happy reading.

Today I will start by posting a brief of a book on quantitative investing that I read this year. I highly recommend this book for all serious investors.

What Works on Wall Street by James O'Shaughnessy.

James O'Shaughnessy was the founder and now Chairman of O'Shaughnessy Asset Management. Patrick O'Shaughnessy, his son, is the host of the extremely good and popular podcast Invest Like the Best (this podcast is a must-listen in my opinion).

The author is one of the pioneers of quantitative investing and has run his firm successfully through multiple market cycles that have proved that his strategies work.

Now to the book. The author starts with traditional active fund management does not work. His approach is to build "indices" or portfolios by various quantitative methods and calculating the performance of the portfolio accurately. He also mentions that it is important to be able to "backtest" his quant strategies over an extended period of time (preferably many decades) to check its reliability across market cycles and events.

The second key concept in the book is that quant strategies help in taking away behavioural biases of the investor. Even the best of investors, often times "goes by the gut" and can make mistakes. He stresses on building models based on "factors" which better determinants of value. He discusses a number of ratios in the book and how to use them in models including their deficiencies.

The book then goes on to explore multi-factor models to improve performance. He also discusses using bringing value and growth factors together in his models, understanding base rates and worst-case scenarios of the strategy that is built.

Some snippets of his wisdom:

If you can’t use strategies, and are inexorably drawn to the stock of the day, your returns suffer horribly in the long run.

The point is that, at some other time in the future, any of the strategies in this book will underperform the market, and it is only those investors who can keep their focus on the very long-term results who will be able to stick with them and reap the rewards of a long-term commitment. Nevertheless, you should always guard against letting what the market is doing today influence the long-term investment decisions you make.

Always focus on strategies whose effectiveness is proven over a variety of market environments. The more periods you can analyze, the better your odds of finding a strategy that has withstood a variety of stock market environments.

There is no point in using the riskiest strategies. They will sap your will, and you will undoubtedly abandon them, usually at their low. Given the number of highly effective strategies, always concentrate on those with the highest risk-adjusted returns.

Unless you’re near retirement and investing only in low-risk strategies, always diversify your portfolio by investing in several strategies.

Note: There are 2 comments about this book that I will make before closing. 
1. This is not an inexpensive book. However, the way I personally think about it is that I am getting the entire lifetime's experience of the author for a couple of thousand rupees. That to me is a bargain.
2. This book may not gel well with "value investors" at first due to its approach. However, it is important to understand the concept of strategies and factors. This book is worth a read just to understand these two concepts.