Challenging quality scoring models on asset allocation strategies of equities

Author: Theodor Munteanu, Quantitative Analyst

Contents
Introduction: ................................................................................................................................................. 1
Question 1: What is quality and what is its relation with other fundamental factors (Size, Value,
Momentum)? ................................................................................................................................................ 2
Proportion of value & quality stocks by sector across top 100 stocks ..................................................... 4
Question 2: Which portfolio strategies consistently outperform benchmark indexes & industrial
averages? ...................................................................................................................................................... 5
Choosing other weighting schemes. Can earnings vol make a good weighting scheme? ........................ 7
Hybrid strategies: Does size matter while mixing with quality portfolios? .............................................. 8
Question 3: What is the risk contribution of the fundamental risk factors on the top quality investments?
.................................................................................................................................................................... 10
APPENDIX .................................................................................................................................................... 13
A1) Definition of fundamental variables ................................................................................................. 13
A2) Selecting the weights in quality score internal method ................................................................... 13
A3) Capital and fundamental weighting indexation in quality portfolios ............................................... 13
A4) Methodology for Common Stock Names (CSN) and Common Percentage Names (CPN) ............... 13
A5) Bibliography ...................................................................................................................................... 14

Introduction:
In this paper I will show the impact of quality scoring model choices on risk-budget, market-cap and
alternative weighting allocation of what it will be defined as “quality” portfolios of stocks from the
european markets.

• Apparently the MSCI benchmark score model (Leverage, Earnings volatility and Profitability) is
not always the best choice when it comes to dynamic short-term alllocation of top quality
stocks, but other factors such as Price variability and investment aggresiveness play a more
significant role in the indexation strategies.

• The fundamentally weighted portfolio, indexed by earnings variability of the top 10 quality
stocks, yields an average annual performance of 23.6% while the MSCI quality index yearly
average performance is 9.9% and the Market Cap weighted portfolio of the same top 10
quality stocks has an yearly average performance between 18.01% (standard MSCI scoring)
and 19.46% (scoring model no. 4) (see the next paragraph for a brief description of the
considered models).
 • ERC portfolios (across top 10 quality stocks) yield more stable, although less spectacular
results than fundamental indexation strategies. Size factor improves significantly the quality
portfolios’ risk-profile, when added (in some cases, 5x sharpe ratios).
• Value has a significant negative risk contribution to quality portfolios. It is a good idea to
diversify quality with value stocks.

Analysis period: 2005-2018. It is based on weekly reported and estimated data of 29 financial variables
for 1038 stocks (historical components of DJ 600 Europe Index).

Stock universe: The universe of stocks is a so-called “Capex-Price Universe”, which is formed by the
most liquid components of Dow Jones Stoxx 600 Europe, having a full data availability in prices
throughout the analysis period and 85% reported CAPEX data availability throughout the same period,
yielding 484 stocks, spread across 17 industrial sectors.

Question 1: What is quality and what is its relation with other

fundamental factors (Size, Value, Momentum)?
As an investment factor, according to MSCI methodology, quality is a synthetic factor that aims to
gauge the stability of earnings, financial reliability and profitability of a company.

My own definition captures also the agressiveness in investments, as well as price variability.

For the definition of fundamental variables see Appendix A1).

To define quality I used two methodologies based on the following idea (see also [2], Appendix, for a
detailed methodology of computing Implied Cost of Equity/Risk Premium):

I regressed Implied Cost of Equity on fundamental factors such as leverage, profitability, price and
earnings variability (vol & beta w.r.t DJ Index), but also on other less frequently used factors such as
Capex/Net Income, Capex/Total Assets or risk-adjusted factors (price \ earnings momentum adjusted by
standard deviation of price/earnings return) leading to several candidate models presented below.
𝟏
𝐶𝑜𝐸𝑖,𝑡 ~𝛼𝐽 + 𝛽𝐽 𝜎(𝐸𝑃𝑆 𝑟𝑒𝑡)𝑖,𝑡 + 𝛾𝐽 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝛿𝐽 𝑃𝑟𝑜𝑓𝑖,𝑡 (𝛃𝐉 = 𝜸𝑱 = 𝜹𝑱 = ≅MSCI model) (M1)
𝟑
𝐶𝑜𝐸𝑖,𝑡 ~𝛼𝐽 + 𝛽𝐽 𝜎(𝑃𝑟𝑖𝑐𝑒 𝑟𝑒𝑡)𝑖,𝑡 + 𝛾𝐽 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝛿𝐽 𝑃𝑟𝑜𝑓𝑖,𝑡 (M2)
𝐶𝑜𝐸𝑖,𝑡 ∼ 𝛼𝐽 + 𝛽𝐽 𝜎(𝐸𝑃𝑆 𝑟𝑒𝑡)𝑖,𝑡 + 𝛾𝐽 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝛿𝐽 𝑃𝑟𝑜𝑓𝑖,𝑡 + μJ σ(Price ret)i,t (M3)
𝐶𝑎𝑝𝑒𝑥𝑖,𝑡
𝐶𝑜𝐸𝑖,𝑡 ∼ 𝛼𝐽 + 𝛽𝐽 𝜎(𝐸𝑃𝑆 𝑟𝑒𝑡)𝑖,𝑡 + 𝛾𝐽 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝛿𝐽 𝑃𝑟𝑜𝑓𝑖,𝑡 + μJ (M4)
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒(𝑖,𝑡)
𝐶𝑎𝑝𝑒𝑥𝑖,𝑡
𝐶𝑜𝐸𝑖,𝑡 ~𝛼𝐽 + 𝛽𝐽 𝜎(𝑃𝑟𝑖𝑐𝑒 𝑟𝑒𝑡)𝑖,𝑡 + 𝛾𝐽 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝛿𝐽 𝑃𝑟𝑜𝑓𝑖,𝑡 (M5)
(𝑖,𝑡)
𝐶𝑎𝑝𝑒𝑥
𝑖,𝑡
𝐶𝑜𝐸𝑖,𝑡 ~𝛼𝐽 + 𝛽𝐽 𝜎(𝐸𝑃𝑆 𝑟𝑒𝑡)𝑖,𝑡 + 𝛾𝐽 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝛿𝐽 𝑃𝑟𝑜𝑓𝑖,𝑡 (M6),𝒊 =stock,𝒕 =time, 𝑱 =sector.
(𝑖,𝑡)

a. The first methodology of scoring consists of placing equal weights on each factor’s z-score. (EW)
b. The second, finds out the influence of each explanatory variable, and uses that as basis for
selecting the coefficient. (See APPENDIX A2) for more details). We call this, alternative weighted
scoring (AW).

In many portfolios cases I choose the 5th and 6th models as best regression & subsequently, scoring
2
models according to 𝑅𝑎𝑑𝑗 & 𝑅 2 incremental contributions and 𝐴𝐼𝐶, 𝐵𝐼𝐶 criterias.
 • Quality is strongly correlated with Value when tail dependence measures such as CSN, CPN
are considered (For details about CSN, CPN, check Appendix A4)). If we count the top 50
positions in both Value and Quality, we can see an average common percentage in names (CPN)
of more than 60% in the alternative weighted scoring model and approx 40% common name
coverage in the equal weighting scheme.
• Quality and Small Cap overlap very little in their tails (around 10% on average), so It is a
potential basis for hybrid allocation strategies. (See Table 2). Also one can observe less model-
dependent results when AW scoring models are considered.
• Quality and Low vol have fairly little stocks in common throughout European markets,
especially if we consider alternative weighted score models. (See table 3)

Table 1: Common stocks names % between top 50 highest Value and Quality companies:
Quality score model |Weighting scheme AW EW
Model 1 67.32% 45.72%
Model 2 66.16% 34.95%
Model 3 66.12% 26.61%
Model 4 67.13% 41.08%
Model 5 66.43% 33.91%
Model 6 67.13% 58.14%

Table 2: Common stocks names % between Size and Quality

CSN (size-quality) EW AW
Model 1 12.13% 12.98%
Model 2 7.92% 12.78%
Model 3 7.34% 12.76%
Model 4 12.48% 13.20%
Model 5 6.50% 12.28%
Model 6 11.23% 12.78%

Table 3: Common stocks names % (CSN) between Low vol & High quality
CSN (low vol) AW (EPS vol) EW (EPS vol) AW (price vol) EW (price vol)
Model 1 5.49% 4.25% 3.71% 3.92%
Model 2 4.81% 17.88% 3.17% 29.47%
Model 3 4.92% 28.29% 3.23% 41.77%
Model 4 5.44% 5.01% 3.63% 4.28%
Model 5 3.83% 20.07% 2.65% 33.29%
Model 6 4.75% 3.70% 3.39% 3.37%
Proportion of value & quality stocks by sector across top 100 stocks

Top 100 value stocks historical sector

'Telecommunication exposure
s' 'Travel & Leisure'
3% Automobiles & Parts
8%
Technology 15%
5% Retail
Personal & 4% Basic Resources
Household Goods 10%
6% Construction &
Chemicals Materials
2% 3%
Financial Services
Oil & Gas 3%
15% Health Care Food & Beverage
3% 2%
Media
Industrial Goods &
3%
Services
Automobiles & Parts Basic Resources 18% Chemicals

Construction & Materials Financial Services Food & Beverage

Health Care Industrial Goods & Services Media
Oil & Gas Personal & Household Goods Retail
Technology 'Telecommunications' 'Travel & Leisure'

Top 100 quality stocks historical sector

exposure (MSCI)
7% 1%2% 5%
2% 2% 3%
11%

4% 16%

14%

2% 22%
9%

Automobiles & Parts Basic Resources Chemicals

Construction & Materials Food & Beverage Health Care
Industrial Goods & Services Media Oil & Gas
Personal & Household Goods Retail Technology
Telecommunications Travel & Leisure

Remark: According to MSCI quality model, there are no companies from Real Estate, Finance /Utilities
sectors.
 Top 100 quality stocks exposure across sectors: Model 2
Basic ResourcesConstruction &
Utilities Materials Food & Beverage
1%
19% Chemicals
7% Care 6%
Health
Travel & Leisure 1%
8% 6%
Industrial Goods &
Telecommunications Services
10% Retail Media 12%
1% Real Estate 8%
Oil & Gas
10% 11%
Basic Resources Chemicals Construction & Materials
Food & Beverage Health Care Industrial Goods & Services
Media Oil & Gas Real Estate
Retail Telecommunications Travel & Leisure
Utilities

Question 2: Which portfolio strategies consistently outperform

benchmark indexes & industrial averages?
Fortunately for researchers, and unfortunately for the general investment public, there is no fixed rule
of choosing the “best” quality models or a guaranteed optimal allocation portfolio.

In this situation, the baseline strategy is to choose the stocks with the highest quality scores and check
different allocations strategies on the stocks found, as well as mixing with other fundamental factors
constituents (Low Vol/ Low size/High Value stocks).

• The average yearly performances of capital weightings of top 10 quality stocks according to the
6 quality scoring models (EW / AW scores) is the highest (19.15%) when the 4th scoring model is
used with equal weights, while standard MSCI scoring (Model 1) yields a 18.08% performance.
• Capital weighted allocations using alternative weighting score models yield poorer annual &
semi-annual returns.

Table 4: Market Cap weighting of top 10 highest quality stocks

Avg y-o-y perf|Quality Weights EW AW
Model 1 18.08% 2.13%
Model 2 -7.34% -2.27%
Model 3 3.75% -2.06%
Model 4 19.15% 2.86%
Model 5 -1.62% 11.77%
Model 6 3.63% 10.99%

Tables 5 & 6: Market Cap Weighting performance of top 25 & top 50 highest quality stock portfolio
Avg y-o-y perf AW EW Avg yearly perf AW EW
Model 1 9.17% 2.68% Model 1 7.02% 2.12%
Model 2 -3.60% -0.68% Model 2 -4.99% -0.83%
Model 3 5.66% 1.19% Model 3 7.01% 0.79%
 Model 4 11.16% 2.99% Model 4 7.88% 2.22%
Model 5 0.76% 6.10% Model 5 3.06% 2.26%
Model 6 2.83% 6.88% Model 6 0.91% 3.43%
One can conclude that model 4 gives the best yearly average performance, whether we use a pool of 10,
25 or 50 best quality stocks.

Note: The average MSCI quality index yearly performance is 9.9% between January 2006 and January
2018 (moving averages are considered, for more robust results).

The correlations between MSCI quality index yearly performances and the equally weighted and
alternatively weighted quality score models can be seen in the table below:

Table 7: Correlation between MSCI index performance and top quality capital weighted portfolios’
performances
MSCI Quality
Correlation EW Index Top 10 QU Top 25 QU Top 50 Qu
Model 1 100.0% 50.7% 65.5% 76.5%
Model 2 100.0% 70.5% 77.8% 74.8%
Model 3 100.0% 63.6% 74.9% 82.2%
Model 4 100.0% 55.9% 67.1% 75.4%
Model 5 100.0% 68.2% 67.5% 74.9%
Model 6 100.0% 56.5% 65.3% 73.3%
MSCI Quality
Correlation AW Index Top 10 QU Top 25 QU Top 50 Qu
Model 1 100.0% 50.3% 66.2% 76.9%
Model 2 100.0% 72.1% 78.7% 83.7%
Model 3 100.0% 63.6% 74.8% 82.2%
Model 4 100.0% 55.1% 67.0% 75.5%
Model 5 100.0% 67.4% 67.0% 75.1%
Model 6 100.0% 56.3% 64.7% 73.2%
One can conclude therefore, that in either case, of quality scores with equal weighting on one hand and
with sectorial adjusted (regression-based) weighting on the other, quality score model 2 (Price
volatility, Leverage and Profitability) gives the best representation of MSCI quality index performance
(70.5% and 72.1% correlation in top 10, EW and AW respectively, 77.8% and 78.7% in top 25, EW &AW
respectively).
Choosing other weighting schemes. Can earnings vol make a good weighting scheme?
So far, we have seen that Models 1&4 with equal scoring weights give significant higher yearly
performances over the MSCI Europe quality Index. However the results are too model-dependent.

Therefore, since most of the scoring models include earnings variability as an explanatory factor, I
replace the Market Cap weighting scheme with 3Y - Earnings variability, but instead of minimizing
(penalizing) the volatility, I will use a direct allocation. (See appendix A3) for more details.)

Table 8: Average annual performance of 3Y EPS var-weighted quality portfolios: EW score models (left),
AW score models (right)

Quality model Top 50 Top 25 Top 10 Quality model Top 50 Top 25 Top 10
Model 1 22.0% 22.1% 22.7% Model 1 28.5% 26.9% 20.8%
Model 2 -5.5% -11.8% -14.7% Model 2 10.2% 7.7% 1.6%
Model 3 12.9% 11.1% 7.6% Model 3 8.0% 4.6% -3.8%
Model 4 13.9% 12.4% 11.5% Model 4 28.7% 27.5% 21.3%
Model 5 1.3% -1.6% -4.2% Model 5 20.5% 20.1% 11.3%
Model 6 4.6% 2.3% -1.7% Model 6 26.7% 26.8% 19.8%

• One can see that alternative scoring models produce positive outputs in virtually all cases while
equally weighted scoring models yield more volatile results.
• Also, the results in the alternate scoring models are superior to those in the equally weighted
scoring models (17.1% overall average for AW models compared to 5.1% overall average for EW
models).
• The 4th scoring model again outperforms the other scoring models (28.7% average annual
return for Top 50 AW, 27.5% average annual return for Top 25 AW), being above all the other
results so far (19.0% for Market Cap indexation and 9.7% average MSCI yearly return).
Figure 2: Evolution of top quality stocks portfolios based on AW quality scoring model 4:
(Profitability, Leverage, EPS variability, Capex/Net Income)

Figure 3: Distribution of 52-week moving averages of 1Y returns

REMARKS:
In the middle of recession, the best 10 quality stocks have strongly outperformed the quality
benchmarks (MSCI Europe Quality).

Hybrid strategies: Does size matter while mixing with quality portfolios?
Key takeaway: The sharpe ratios of ERC (equally risk charged) portfolios and their absolute returns are
significantly increased if we add a size component to the quality stocks.

Note: I used DBDCONIA as risk-free performance index.

We have seen in the first section, that quality and value stocks overlap considerably in their top
rankings, while (quality, size) and (quality, low-vol) form pairs that have almost empty common tails in
their rankings.
As one can see below, in risk-parity case, low size does not improve significantly the sharpe ratios of top
10 quality equally risk charged (ERC) portfolios. In the figure below you can see for scoring model 1, the
history of backtested quality portfolios performances. Similar results are obtained for other scoring
models.

The capital weighted behave better in terms of crisis, have lower sharpe ratios.

If we build cap-weighted portfolios with top 10 smallest cap & top 10 highest quality stocks, we get the
following sharpe ratios & average returns summarized in the following tables:
Table 9: Average sharpe ratios (2006-2018)
Quality model Top 10 Quality Top 10 Quality + Top Small cap
 Model 1 0.799 0.941
Model 2 0.089 0.587
Model 3 0.342 0.717
Model 4 0.735 0.903
Model 5 0.051 0.554
Model 6 0.313 0.705
Table 10: Median sharpe ratios (2006-2018)
Quality model Top 10 Quality Top 10 Quality + Top 10 Small cap
Model 1 0.459 0.822
Model 2 -0.188 0.456
Model 3 0.167 0.714
Model 4 0.343 0.758
Model 5 -0.134 0.529
Model 6 -0.044 0.456
Table 11: Average 1Y portfolio returns (2006-2018)
Quality model Top 10 Quality Top 10 Quality + Top 10 Small cap
Model 1 13.8% 13.3%
Model 2 -5.4% 5.1%
Model 3 3.7% 8.4%
Model 4 12.2% 12.4%
Model 5 -0.9% 6.4%
Model 6 0.7% 8.8%

Question 3: What is the risk contribution of the fundamental risk factors

on the top quality investments?
CONCLUSIONS:

1. Adding value to quality portfolios decreases significantly the portfolio risk.

2. Small cap stocks have positive risk contribution towards quality portfolios. Diversifying quality
with small cap is not such a good idea, but rather with value stocks, in order to increase
sharpe ratios.

I have selected for the research the top 25 best quality scored companies for the 2005-2018 period.
Table 12: Top 25 stocks overall according to Scoring model 1: 𝐶𝑜𝐸𝑖,𝑡 ~𝛼1 + 𝛼2 𝑃𝑟𝑜𝑓𝑖,𝑡 + 𝛼3 ⋅
𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒𝑖,𝑡 + 𝛼4 𝜎(𝐸𝑃𝑆𝑟𝑒𝑡 , 52𝑊, 𝑡 − 3𝑌: 𝑡)𝑖,𝑡
Company Sector Company Sector
Bellway p.l.c. Personal & Household Goods Volkswagen AG Pref Automobiles & Parts
Balfour Beatty plc Construction & Materials Daimler AG Automobiles & Parts
Schroders PLC Financial Services Bayerische Motoren Werke AG Automobiles & Parts
BAE Systems plc Industrial Goods & Services Porsche Automobil Holding SE Pref Automobiles & Parts
Rio Tinto plc Basic Resources Statoil ASA Oil & Gas
Carillion plc Industrial Goods & Services Yara International ASA Chemicals
 BP p.l.c. Oil & Gas Royal Dutch Shell Plc Class A Oil & Gas
Trinity Mirror plc Media Royal Dutch Shell Plc Class B Oil & Gas
AstraZeneca PLC Health Care Total SA Oil & Gas
OMV AG Oil & Gas TGS-NOPEC Geophysical Company ASA Oil & Gas
Renault SA Automobiles & Parts TP ICAP plc Financial Services
Volkswagen AG Automobiles & Parts Boliden AB Basic Resources

If we consider the Market Capitalization indexing, the risk contribution of the main fundamental risk
factors depend on the investment horizon. Adding more quality stocks to 25 market-cap weighted top
quality portfolios is a good idea on the short run, but on a medium term it is advisable to reshift towards
value / momentum stocks to improve the risk profile.

For model 1 one can see the following average risk contributions for the period 2006-2018:

Table 13: Adjusted risk contributions when 𝑹(𝒙) = √𝒙′ 𝜮𝒙, Model scoring 1,𝜮 =covariance matrix of
returns, x = structure of the portfolio (Market Cap weighted)
Factor\Return 1M returrns 3M returns 6M returns 1Y returns
MSCI MMT 33.5% 57.1% 24.4% -0.5%
MSCI Growth -18.0% -51.4% -19.2% 19.8%
MSCI Value 75.7% 68.2% -24.0% -30.7%
MSCI Quality 90.6% 94.1% -10.1% -33.3%
MSCI Low vol -64.7% -76.9% 15.9% 15.2%
MSCI High dvd -13.1% 2.6% 40.0% 71.1%
MSCI Small Cap -7.5% 1.8% 69.9% 57.7%
For short-term investment horizons, the quality portfolios are very sensitive towards the quality index,
and the more weight added on the quality, value and momentum, the greater the risk is.

One might consider for diversification the Low vol and Growth stocks.

For longer terms such as 6 months or 1Y, quality stocks are less volatility when quality exposure is
added. The riskiness increases w.r.t all the other factors, when corresponding exposures are added.

Remark: The specific risks are insignificant compared to the common risk factors.
APPENDIX
A1) Definition of fundamental variables
𝑁𝑒𝑡 𝐷𝑒𝑏𝑡 12𝑀𝐹 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 12𝑀𝐹
Leverage is defined here as 𝑀𝑘𝑡 𝑐𝑎𝑝
, while 𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 = 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
(both factors
are on a market-value based, not on a book-value based, which is more significant in our situation).

Price & earnings variability = annualized standard deviation of weekly returns for a rolling 3Y period.

Value = a linear combination of P/E, P/B, CFO/MV scores.

A2) Selecting the weights in quality score internal method

Step 1: For each model considered (M1-M6), we run first the z-scores of each component

Step 2: The coefficients accompanying each factor should be reflected by their influence on the
dependent variable (Cost of Equity) therefore we run regressions between the z-scores of the
dependent variable and the z-scores of each explanatory variable.

To exemplify, the first model (M1) is: 𝑧(𝐶𝑜𝐸𝑖,𝑡 )~𝑎1𝑖 + 𝑎2𝑖 𝑧(𝑃𝑟𝑜𝑓𝑖,𝑡 ) + 𝑎3 𝑧(𝐿𝑣𝑔𝑖,𝑡 ) + 𝑎4 𝑧(𝐸𝑃𝑆 𝑣𝑜𝑙𝑖,𝑡 )
̂
(𝑎 𝑖 ̂ 𝑖 ̂ 𝑖
2) (𝑎 3) (𝑎 4)
and I choose as quality weights 𝑤1𝑖 = , 𝑤2𝑖 = , 𝑤3𝑖 = where
|𝑎2𝑖 |+|𝑎3𝑖 |+|𝑎4𝑖 | |𝑎2𝑖 |+|𝑎3𝑖 |+|𝑎4𝑖 | |𝑎2𝑖 |+|𝑎3𝑖 |+|𝑎4𝑖 |
̂𝑖 , 𝑎
𝑎 ̂𝑖 ̂𝑖
2 3 , 𝑎4 are the regression coefficient estimates.

1 + 𝑧, 𝑧 > 0
Step 3: The function 𝑓(𝑧) = { 1 is applied to the scores obtained at Step 2, yielding the
1−𝑧
,𝑧 < 0
quality scores (as in the MSCI methodology).

A3) Capital and fundamental weighting indexation in quality portfolios

Market cap indexation steps

• I compute the Quality Scores according to the methodologies presented in A1) and A2)
• 𝑄𝑢𝑎𝑙𝑖𝑡𝑦 𝑤𝑒𝑖𝑔ℎ𝑡𝑖,𝑡 = 𝑄𝑢𝑎𝑙𝑖𝑡𝑦 𝑠𝑐𝑜𝑟𝑒𝑖,𝑡 ⋅ (Market Cap weight in the top 10 quality baske𝑡)𝑖,𝑡

Fundamental vol indexation

• Compute the 3Y EPS consensus estimates volatility 𝝈𝒊 (𝒕 − 𝟑𝒀, 𝒕) (standard deviation of

annualized weekly % in changes of EPS)
𝝈(𝒊,𝒕)⋅𝑸𝒖𝒂𝒍𝒊𝒕𝒚 𝒔𝒄𝒐𝒓𝒆
• 𝒘𝒕 = 𝚺 𝝈(𝒊,𝒕)⋅𝑸𝒖𝒂𝒍𝒊𝒕𝒚 𝒔𝒄𝒐𝒓𝒆𝒊,𝒕
𝒊 𝒊𝒕

A4) Methodology for Common Stock Names (CSN) and Common Percentage Names
(CPN)
• Find at the end of every week the highest/lowest 𝑘 values for each factor (quality, size, growth,
value, vol) (In my study 𝑘 ∈ {50,100}), or use a rank function (in ascending / descending order)
𝑗 𝑗
• Find (𝑐𝑎𝑟𝑑({i|rank(𝐹𝑖,𝑡1 )≤ 𝑘}∩ {𝑖|𝑟𝑎𝑛𝑘(𝐹𝑖,𝑡2 ) ≤ 𝑘}))/𝑘, ∀𝑖, 𝑡 ∈ {1,2, … , 𝑁}, 𝑡 ∈ {1,2, … , 𝑇}
where 𝑗1 , 𝑗2 ∈ {Low vol, Quality, Momentum, Growth, Value, Size} and 𝑁 = number of stocks,
𝑇 = number of registered dates.
A5) Bibliography
1. MSCI quality, value & Growth methodologies
https://www.msci.com/eqb/methodology/meth_docs/MSCI_Quality_Indices_Methodology.pdf