…A Quantitative Approach Global Asset Allocation Term 3, 2005 Matthew Morse Jason Teeters J.J. Haines

Overview Hypothesis: Develop a market-neutral long/short strategy Motivated by a “pairs trading” strategy which is designed to hedge industry specific risk Identify a dynamic portfolio strategy which outperforms a general pairs trading strategy through the creation of a “basket” of securities Industry-specific long and short “baskets” are identified on a monthly basis through a screen of targeted fundamental factors Identify industry sectors which consistently produce excess returns

Overview Methodology: Identify industries and potential fundamental factors Screen and alpha test individual factors across industry sectors Score and combine individual factors Alpha test combined industry long/short “baskets” Evaluate which industries produce consistent excess returns Evaluate trading strategies

Industries Communications Manufacturing Transportation Consumer Healthcare

Screens Factors: Short Interest - total short positions currently open for a given equity as a percentage of total shares Fundamental Debt Factor - incorporates information about cost of debt and leverage ratio Change in Consensus – Percent change in EPS estimate (IBES)

In Sample

Healthcare Communication Consumer Products

Manufacturing Transportation

Healthcare – In Sample

Communications – In Sample

Consumer – In Sample

Manufacturing – In Sample

Transportation – In Sample

Out of Sample

Healthcare Communication Consumer Products

Manufacturing Transportation

Healthcare – Out Sample

Communications – Out Sample

Consumer – Out Sample

Manufacturing – Out Sample

Transportation – Out Sample

Optimization

Optimization Value Weighted Equal Weighted

Conclusions Intra-sector excess returns appear to be consistently available Inconsistent “in-sample” and “out-of-sample” results within certain industry sectors Additional analysis should lead to effective factors which could consistently produce intra-sector excess returns

Next Steps Develop and evaluate additional factors which isolate industry specific excess returns Test additional industry sectors and sub-sectors in-sample Vary factors weights across industries Evaluate migration of stocks within fractiles Develop and evaluate sector-specific, and overall, trading strategies as part of an overall hedge fund charter