Engineering Investment Process.

Making Value Creation Repeatable

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Engineering Investment Process
 Quantitative Finance Set
coordinated by
Patrick Duvaut and Emmanuelle Jay

Engineering
Investment Process

Making Value Creation Repeatable

Florian Ielpo
Chafic Merhy
Guillaume Simon
First published 2017 in Great Britain and the United States by ISTE Press Ltd and Elsevier Ltd

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Notices
Knowledge and best practice in this field are constantly changing. As new research and experience
broaden our understanding, changes in research methods, professional practices, or medical treatment
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 Foreword

Jean-Philippe B OUCHAUD - Chairman & Chief Scientist, CFM, PARIS.

“The time is gone when asset managers could deal from the seat of their pants with
portfolio construction, risk constraints and transaction costs. These issues deserve to
be treated with scientific tools and watch-maker precision, whether or not trading
decisions themselves come from quantitative models. This book provides a
comprehensive and insightful account of the recent breakthroughs in the world of
quantitative asset management.”

Albert D ESCLÉE - Managing Director, Quantitative Portfolio Strategy,

BARCLAYS , L ONDON.

“The authors are market practitioners who provide realistic, implementable

approaches to portfolio construction. This is an excellent book that should appeal to
all professional investors.”

Fiona F RICK - Chief Executive Officer, U NIGESTION , G ENEVA.

“Models in finance are not grounded on “laws of nature” but are built through a
process of statistical learning guided by economic and market intuition. This book
creates a bridge between the academic financial theory and the practicality of
managing money on a day by day basis. It articulates one by one all the steps that
need to be engineered in order to build a sound investment process from market
analysis, allocation process or risk management. The book also illustrates that risk
belongs at the centre stage of asset allocation and shows the value of an holistic
approach to risk management embracing its different aspects from statistical
measures to market valuation , macro-economic assessment or liquidity criteria.

I would have loved to have such a book when I started working in asset management.”
x Engineering Investment Process

Ibrahima KOBAR - CIO Fixed Income, N ATIXIS AM, PARIS.

“I’ve always been a huge fan and advocate of investment processes based on the
combination of a skilled portfolio manager supported by strong quantitative and
qualitative analysis. This approach is key for a value creation for the investors. No
other book serves the need of a reader who seeks a fuller understanding of the
quantitative analysis of an investment process. This is a must read for any
practitioner: portfolio manager, investor, consultant...”

Charles-Albert L EHALLE - Senior Research Advisor, CFM - Visting Researcher,

I MPERIAL C OLLEGE , L ONDON - Member of the Scientific Committee of the
French regulator, AMF - Chair of Euronext Index Advisory Group.

“Ielpo, Merhy and Simon’s book is unique in the way it combines theory and
practice, with no concession on the statistical science. Far from a boring list of well
known formulas, each chapter covers an important building block of quantitative
portfolio management. Examples are carefully chosen not only to explain how to use
theory, but each of them sheds an interesting light on important features of returns
dynamics. Authors cover reliable beta estimation, alpha identification, inter-temporal
portfolio construction, back testing and performance analysis. It gives crucial clues
to combine in practice these essential steps of the lifecycle of a portfolio. The two last
chapters focus on very important topics that are often addressed in a few paragraphs
and deserve more. I strongly recommend this book to young practitioners and young
researchers who want to invest themselves in quantitative asset allocation.
Bibliographical references will allow readers to go further on their own, and an
appendix covers necessary mathematics. Therefore more experienced practitioners
would read it with interest too.”

Thierry RONCALLI - U NIVERSITY OF E VRY.

“This book covers everything from asset universe and risk factors to portfolio
construction and backtesting in order to understand and build investment processes.
Besides theoretical aspects of quantitative strategies, the authors also provide an
extensive treatment of practical aspects of these topics. This book is highly
recommended for students and investment professionals, who want to benefit from the
long experience of the authors in quantitative asset management.”
 Preface

Quantitative finance literature has made countless contributions in various fields,

from very general topics to very specific ones. To our surprise, we rarely found books
dealing with the complete investment process. With more and more sophisticated
products, an increasing number of participants, increasing complexity and
continuously increasing assets, it is becoming necessary to handle an investment
process with an engineering approach. We wanted to write the book we would have
wanted to read as young practitioners. Therefore, our goal is to make it as useful a
tool for readers, from students to experienced professionals, by presenting the
concepts of financial markets as much as possible through a pedagogical prism.

Daily work on the financial markets is often a production concern and a quest for
performance that makes it very difficult to step back and have a critical viewpoint of
one’s own process. It makes it difficult to have the clarity of mind to discard the use
in production of a seemingly profitable strategy. When performing some research, it
is not so easy to assess the quality of a given research paper that is found randomly.
And most of the time (fortunately not always), books focus on very specific issues and
theoretical aspects, which may be far from practical considerations and applicability.
Conversely, students have time to study but it is difficult for them to have a neat idea of
what the daily life of a financial practitioner is. Learning sophisticated techniques is a
necessity to survive in today’s quantitative financial world; however, it may sometimes
be difficult to get a clear picture of the pertinence of each technique on real data.
Moreover, some aspects of the “practical survival kit” of a quantitative analyst are not
taught and have to be discovered “live” when working with empirical data.

What is this book about? When building or analyzing an investment process, there
are a couple of essential steps to be followed: we particularly want to highlight and
explain throughout the following chapters the articulation of all these steps. Despite
the large literature dedicated to selected pieces of this sequence of steps, few people
have taken on the difficult task of articulating each of these elements together. This
xii Engineering Investment Process

book aims at providing a stylized view on the key elements on which any investment
process should be built by bringing consistency to the engineering of this process.

We want to bring a unified and scientific view of what an investment process

should be, in order to allow investors to generate performance recurrently. The
principles and features of a fund’s investment process are unique to each fund and
reflect its managers’ experience and beliefs. They nonetheless drive the resilience of
the fund’s performance. We also conceive this book as a sanity checklist for any
manager to assess the quality of her or his process. It may also be viewed as a road
map for quants, whatever their asset class and whatever their experience. However,
this is not a financial econometrics textbook per se, and for lack of space, we cannot
deal with every subject or every detail of the points we tackle. In this respect, we
have made a particular effort to indicate the major references in each field, also
considering our work as a “scientific hub” to guide our readers towards the most
useful and qualitative contributions in specific fields. We will not provide a guide to
so-called winning strategies either. Strategies illustrate the idiosyncrasies of fund
managers, therefore strategy construction is out of the scope of this book. This book
will be neither a handbook of techniques nor a collection of recipes. We do not aim to
provide a heavy encyclopedia of unreadable equations and will carefully select the
theoretical aspects that are relevant in the daily life of fund management in order to
wrap up concepts, make links and explain theory when needed. We do not disregard
theory as we truly believe in the power of a quantitative approach. We simply want to
put financial mathematics and econometrics in their rightful place: an incredibly
useful set of tools to increase our understanding of markets.

We see this book as the blending of our academic research with our practical daily
experience as quantitative analysts, fund managers and economists. We believe that
this balance, between academic and practical experience as investment management
professionals, will give this book a specific identity for readers interested in finance,
whatever their degree of experience. And if it turns to be a useful tool for our readers,
our wish will have been fulfilled!

Acknowledgments

The present work owes a lot to enlightening discussions with a lot of people. We
would like to thank people who had, directly or indirectly, a concrete influence on the
writing and content of this book. First, we would like to thank Patrick Duvaut and
Emmanuelle Jay for their support, help and advice in the development of this project.
We also want to thank (in alphabetical order) Philippe Bernard, Guillaume Bernis,
Ling-ni Boon, Axel Botte, Jean-Philippe Bouchaud, Joël Bun, Mabrouk Chetouane,
Rémy Chicheportiche, Stefano Ciliberti, Albert Desclée, Grégoire Docq, Fiona Frick,
Matthieu Garcin, Ibrahima Kobar, Laurent Laloux, Charles-Albert Lehalle, Yves
Lempérière, Angelo Pessaris, Nathalie Pistre, Marc Potters, Sara Razmpa, Thierry
 Preface xiii

Roncalli, Mathieu Rosenbaum, Emmanuel Sérié, Benoît Sévi, Anna Simoni and
Jérôme Teiletche for indirect or direct discussions, encouragements, remarks,
comments or ideas.

F.I. will never be able to thank enough Patrick Zweifel for having inspired once
again the elements of macroeconomics in this book. He also wishes to thank
Dominique Guégan for not having let go of the preposterous student he was in 2004.

C.M. would like to thank Jacques Aben, Dominique Guégan and Jean-Marie
Rousseau for their support and enlightenment.

G.S. would also like to thank Serge Darolles and Jean-Pierre Florens for their help,
support, influence and scientific inspiration through years.

We moreover bear alone the responsibility of the views and thoughts exposed in
the present book. And obviously, all the errors remain ours.

Florian I ELPO
Chafic M ERHY
Guillaume S IMON
December 2016
 Introduction

“It takes 20 years to build a reputation and five minutes to ruin it.
If you think about that, you’ll do things differently. ”
Warren Buffet1

I.1. Making value creation repeatable

Since the financial crisis of 2008, financial markets have been under pressure and
heavily criticized. Their role and nature are challenged, heated public debates on
their claimed usefulness for the real economy have taken place. In this context, bad
performance could wreck a fund manager’s reputation and perspectives. Performance
can be disappointing because of bad strategies and a low ability to forecast markets
moves. Outstanding prediction skills can also be spoiled by a poor risk management,
an inaccurate allocation scheme, or a lazy study of the overall process.

Such systematic weaknesses of the industry appear in the data. Studying hedge
funds’ databases, academics have observed that the reason for a fund to exit from a
database may be explained by a voluntary exit (funds locking up after reaching a
sufficient capacity and in no need of more clients) or more simply by the death of the
fund. Hedge funds show in general a high degree of attrition within each year, even in
favorable periods2 which is much higher than for mutual funds. Statistical counting
for attrition and the instantaneous probability of failure are two different concepts,
yet provide the same message: funds are more fragile in their early years. Young
funds have a greater probability of dying and disappearing from databases [BRO 01],
[AMI 03]. The most fragile funds do not even have the opportunity to survive long
enough to enter databases: they die before having time to display figures and collect

1 Source: http://business.time.com/2010/03/01/warren-buffetts-boring-brilliant-wisdom/.
2 Around 15 or 20% in the 1987–2001 period ([FUN 97], [BRO 99], [AMI 03]).
xvi Engineering Investment Process

assets. The estimation of the instantaneous probability of dying is still a debate

[GRE 02], [GRE 07] but it asks fundamental questions. Do fund managers benefit
from their experience, does this explain why aged funds are less likely to die? Do
young managers have the time to show their skills? Does it depend on market
conditions? It all boils down to a simple yet striking fact: typically, all things being
equal, after three years of activity, half of the funds may have shut down or have gone
bankrupt. This proves that a robust investment process is necessary to survive
sufficiently longer in the financial universe. This may not be sufficient but having a
world class and organized process should help in making value creation repeatable.

I.2. Why do we allocate?

I.2.1. From passive to active management : the rise of indices

The historical context of indices and risk-based investment throughout the 20th
Century and the beginning of the 21st helps a lot to understand how people conceive
the evolutionary links between performance and portfolio allocation. In the 1950s,
Harry Markowitz, through his contributions in [MAR 52], [MAR 59], laid the
foundations of Modern Portfolio Theory: his work helped to improve the
understanding of diversification as a way to increase risk-adjusted returns. He also
settled the use of (co)variance to model risk and gave birth to the concept of efficient
frontier. In an illuminating review of the historical aspects of Markowitz allocation,
Mark Rubinstein recalls that initially, the link between the variance of assets and the
variance of the portfolio was also identified at the same period by [ROY 52] who also
developed an equivalent concept of efficiency. Markowitz’s theory allows the investor
to shift himself along the efficient frontier (Markowitz however recognizing the
novelty of the approach of Roy at the same time, see [RUB 02]).

Beyond the mean-variance optimization framework, the Capital Asset Pricing

Model (henceforth CAPM) states that when markets are at equilibrium, any efficient
portfolio should be a combination of a risk-free asset with an optimal-tangency
portfolio whose weights are only determined by market capitalization of the stocks.
The messages of the CAPM must not been assimilated to those of mean-variance
allocation. However, they share an important influence on modern finance. CAPM
has been independently developed by [TRE 07], [TRE 61], [LIN 65], [SHA 64], and
[MOS 66] (see also e.g. [KOR 99] or a the recent review by [PER 04]). CAPM builds
on the work initiated on mean-variance by Markowitz in the 1950s with his seminal
paper [MAR 52]. The optimal portfolio is made of all available assets whose weights
are all relatively proportional to their market capitalization. This portfolio helps the
theory of efficient markets to be self-fulfilling since tracking this portfolio will
naturally reinforce the relative market-capitalization structure at equilibrium.

However, if investors seek to replicate this target, their resulting portfolios are
bound to be sub-optimal with respect to this benchmark once costs are taken into
 Introduction xvii

account. Any investor deviating from this target should end within the efficient set,
due to fees and transaction costs. And this is even if the turnover of the portfolio is
the lowest possible since the natural evolution of prices univocally affects the market
capitalization and therefore determines the weights of the portfolio. Consequently,
it was easier for investors to buy ready-made market-capitalization indices. Those
indices have naturally gained the name “passive” investing because of this mechanism
and the self-realizing way of computing weights. This explains, for years, the success
of market capitalization indices since they offer the most straightforward and direct
access for investors seeking exposure to equity markets, added to the fact that they
have deep roots in academic literature and the theory of efficient markets.

Does this leave some space for generating extra performance? If not, close this
book and contact any market participant able to sell you some market-capitalization
weighted index. End of the story? Of course not. The CAPM bridged a gap at a time
where empirical evidence between risk and return were not heavily investigated and
rather helped to formalize the theory of decision in the presence of uncertainty.
Naturally, not all market participants abide by this approach, and this creates
distortions that prevent markets from being at equilibrium, generating trading.

Are market-cap indices problematic? Obviously not since they are still the object
of a large amount of money invested and bear an economic representiveness. Yet, it
is difficult to conceive nowadays market-cap indices as the one and only holy grail
for every investor. Why? First, their optimality is questioned. Empirically, it has been
reported that market-cap indices are in fact not optimal according to real data (see e.g.
[THO 06], [CLA 13b] and also our discussion below on the low-volatility anomaly).
And there are also theoretical arguments that disqualify passive indices as optimal
investments. Those arguments, that we relay here, have been addressed in the work
of [HAU 91] which is one of the first contributions to consider market-capitalization
weighted indices as “inefficient investments”. They underline that as soon as the usual
fundamental assumptions behind the theory do not hold, the capitalization-weighted
portfolios are no longer efficient.

Second, investors may be constrained in practice: this invalidates the full

application of the theoretical CAPM setting. Examples of such constraints are those
related to short-selling. Since they appear to be constraints that are (excluding
frictions due to broker and exchange fees) the more binding ones, and the first
departure from theory one investor may face when trading in practice (see for
instance [JAC 05] and references therein). In addition to the constraints they may
face, and independently of their own appreciation of future market evolution,
investors may differ on numerous aspects: regulation; geographical parameters and
exposition to taxes; operational constraints: infrastructures, execution abilities,
latency; access to data; disagreement on return and risk estimation; etc. There
consequently remains an uncompensated risk meaning that for the given level of
return of market-cap indices, there are still portfolios with lower risk. Let us highlight
xviii Engineering Investment Process

that those conclusions are valid even in an informationally efficient world, this not
being a case against market efficiency in itself [HAU 91].

Elaborating on this, a (bad) argument to convince yourself that all hope is not
gone would be that trading still occurs every day on the markets! Investors and
market participants still try to reap each day some benefit from the financial markets
with a variety of views and bets, in a context close to that of [HAU 91]. What would
be the motivation for hundred of thousands of practitioners to fight for portfolios that
would be doomed to be sub-optimal and inefficient? Of course, this cannot be
considered as a grounded argument. Yet, it illustrates that even with the same
constraints and mandates, investors differ in their views and habits and have
heterogeneous expectations and behaviors. There are also biases and preferences for
domestic assets; divergence on macro and economic forecasts; different risk
estimation methods and measures; wide scope of risk aversion; overconfidence;
appetite for lottery-like assets or alternatively seeking defensive bets; etc.

I.2.2. Beating the benchmark

But is everyone able to beat (or at least consistently positively deviate from) the
market-capitalization benchmark? This is a more subtle question. In order to
outperform, you must have a strategy, and also some skills to follow and implement
this strategy. Not every investor is qualified or able to do it (see again e.g. [PER 07]).
The fact that managers effectively add value is still part of a live debate. Therefore,
any investor willingly and dynamically managing his or her portfolio with an aim to
produce a better performance than the passive indices has naturally been called an
active manager. Managing actively is a notion that is relative in time and style (see
below) and therefore quite diffuse, but the first meaning is that an active manager is
believed to add value by deploying skills to deviate from passive benchmarks
represented by market-cap indices.

I.2.3. Deviating from a benchmark

A major contribution to understanding the debate between passive and active

management is the paper of [CAR 97] that dismisses the general existence of added
skills in mutual performance, in contradiction to the first results of [HEN 93].
Deviating from a benchmark may be understood under a quite general meaning: all
fund managers do not compare, of course, to a benchmark, equity or no equity. We
want to dissect and illustrate here the historical mechanisms that help to understand
how performance generation is considered nowadays. Of course, managers seeking
total returns, managing absolute return processes, Hold to Maturity, etc. qualify for
the definition of active managers in such a discussion, and the notion is, in a way,
related to the message conveyed by [GRI 00] who consider that active management is
intrinsically linked to forecasting.
 Introduction xix

In the following, we will use the term alpha as a proxy for extra-performance
with respect to “a” benchmark. The true econometric definition of the alpha, as
originally introduced by [JEN 68], is linked by essence to the beta, i.e. the sensitivity
to the benchmark, the two quantities having to be determined jointly. However, in
this qualitative introduction, we instead speak about a general and fuzzy view of
alpha, which has to be understood under a lazy proxy of the extra-performance
generated when compared loosely to benchmarks including performance of
competitors. Under this very crude view of alpha, we may also understand this term
as the attractiveness that a fund manager may have in the eyes of potential investors.
The more precise the definition of the benchmark, the more relevant the alpha. In this
context, the active shares are the measure of the proportion of a portfolio that differs
from a market-cap weighted benchmark (based on the individual deviations of the
weights at the asset level). Whereas the tracking error measures how much the
portfolio differs from the benchmark at the aggregated risk level. Technically, is
market-capitalization the only prism through which we must see passive investment?

The notion of an index was not new in the middle of the 20th Century when the
Modern Portfolio Theory arose3. The DJIA (Dow Jones Industrial Average) equity
index was created in 1896, whereas the first index, the DJTA (Dow Jones
Transportation Average, still defined today) was created in 1884. Standard & Poor’s
developed its first index around 1923, and built the current S&P500 equity index as
we know it now in 1957. At this time, an index was most of all designed to tell an
economic story and to aggregate in one single number the state and economic
perspectives of an equity market, of one sector or of one geographical area. Dow
indices began to show a non-trivial weighting in 1928 where some price-weighting
was introduced, whereas S&P indices were already market-cap weighted, following
Irving Fisher’s intuition. However, things really began to change in the 1970s. In
1971, Wells Fargo launched the first indexed account for the Samsonite company; the
people behind this product were John McQuown, James Vertin and William Fouse,
elaborating on the previous works of [SHA 64], [FAM 65] or [JEN 68]. Wells Fargo
continued an indexed investing activity in the following years, while in 1975
Vanguard and John Bogle launched the Vanguard First Index Trust, one of the first
index mutual funds. What really changed is that such an index became investable i.e.
buying one single product allows you to track the desired index. In the stream of the
disaster of October 1987, the first ETF (Exchange Traded Fund), the SPY, was
created in January 1993 to replicate the S&P500 index. John Bogle even assisted
Nathan Most and Steven Bloom as the Vanguard fund could be considered as an
inspiration for ETF creation. SPY is the security that is now the most traded in the
world, ETFs representing a worldwide asset of $3 trillion and may now be the easiest
way to gain exposure to nearly any given index. For more figures and an inside story
on ETFs see the fascinating story related in [BAL 16]. Before that, the first bond

3 [LO 16] provides an interesting review of the history of indices from which some of the events
described here are taken.
xx Engineering Investment Process

index fund appeared in 1986, and the first international share index fund was created
in 1990 (see [LO 16]). This is the history of descriptive, investable or non-investable
indices.

In fact, other indexing strategies may integrate the category of passive investing.
Key elements for an index definition are for example defined and highlighted in
[GAN 12]: a great capacity and a sufficient liquidity; it can be replicated in a
systematic and objective way; finally, the index that is built must have a
representativeness. [LO 16] proposes a definition that is quite similar, that is to say “a
portfolio strategy that satisfies three properties”: a strategy that is transparent,
investable, and systematic in the sense that it is completely rule-based and without
any discretionary intervention. Lo asks as Merton the fundamental question of “what
function does an index serve” and identifies two different aspects of modern indices:
informational purpose to wrap up economic insights; and benchmarking purpose to
serve as a reference for active managers.

Rather than separating active and passive indices through a proximity with
market-cap weighting, [LO 16] makes a distinction in the sense that traditional
indices are called “static” and sophisticated ones “dynamic”. [GAN 12] identifies for
instance 5 indexation schemes: their categorization (that we restate here) is not an
official representation but it enlightens the debate. The first set of indices covers
price-focused indexing (which is clearly related to market-capitalization indices).
The second kind is price-agnostic indexing, quite well illustrated by
equally-weighting the assets within the index (see section 3.6.1.1). Third,
fundamental indexation (see also [ARN 05] or [CLA 13a] as a reference) uses
variables such as dividends and fundamentals (income, book equity, sales,
employment, etc.) to propose new, transparent weights as an alternative to generate
mean-variance efficient portfolios. We may also speak about return-focused indexing
(quite close to the Markowitz framework) and about risk-focused indexing
(risk-parity, minimum variance: we will handle this approach in detail throughout
section 3.6.1). All these approaches are only ways to propose alternatives to
market-capitalization indices while sharing the fact that they are clearly defined,
transparent and explicit. Recently, [CLA 13b] finds that in recent years, a rather large
number of alternative indexing methods would have given more profitable
risk-adjusted performance than the traditional market-capitalization index. And even
that many random choices could have led to more satisfying a posteriori results than
the market-cap index! Their point is that since the end of the 1990s and the beginning
of the 2000s, the market-cap indices have provided disappointing results in the
absolute. See also [CHO 11] for an in-depth study, comparison and factor analysis.
Those alternatives are still trying to redefine not the notion but the definition of a
benchmark, several of them are trying to be more mean-variance efficient
(fundamental indexation for instance) whereas for others (minimum variance e.g.)
mean-variance efficiency should (optionally) arise empirically as a by-product.
 Introduction xxi

I.2.4. Active management and the financial industry

It is interesting to discover how the industry, seen as a whole, has positioned itself
with respect to the active management question. We want to make it clear that we are
not expressing a personal view on the topic detailed below: by restating the figures and
findings drawn from the academic literature, we instead want to illustrate the difficulty
of reaching a clear consensus on the sources and drivers of alpha generation.

Alternative indexation methods remain transparent benchmarks and we will

extend below the discussion on extra-performance and indices built on systematic
strategies. But generating performance remains hard work for institutional investors
like mutual and pension funds, as well as for other participants from traditional asset
managers to hedge funds. For instance, the evidence that mutual funds managers are
able to generate a significantly superior performance is, if not unclear, at least not so
frequent or not so persistent (see for instance [FAM 10] or [WIM 13]). [JOH 15]
finds for instance that even recently in the US, actively managed funds are not able to
over-perform their passive counterparts (when profit is computed net of fees).

Moreover, this incapacity is more pronounced for funds that ask for large fees,
and those funds survive even on a shorter period. In a recent piece of literature,
[KOS 06], [JIA 07] or [CRE 09] among others give insights to show that in some
situations managers may have some added value in their investments. [KOS 06]
shows that the distribution of the cross-section of mutual fund estimated alphas is
non-normal and rather complex. They conclude that funds or managers heavily
diverge in their attitude towards risk, and in their idiosyncratic alpha: this may be
explained by the diversity of approaches, cultures, constraints and mandates. Only a
fraction of managers end-up with a profitable stock-selection after costs, but
hopefully this superior alpha seems to be persistent. [CRE 09] finds that funds that
allow us to deviate in a large proportion from the benchmark tend to outperform the
benchmark after costs, in contrary to less actively managed funds (with the smallest
deviation relative to the benchmark). This is consistent with the findings of [KAC 05]
whose results are in favor of active management delivering performance in the stream
of effective bets on industry.

The contradictions of the academic literature also appear in the contrasted results
on factor timing. An early work of [DAN 97] finds that mutual funds managers may
add some alpha with a pertinent stock picking rather than with an effective factor
timing, whereas some years later, [JIA 07] finds some evidence to the fact that
mutual funds do gain performance due to their timing ability. In fact, using a superior
framework for information processing, they may appear more concentrated and
playing some industrial bets. This is quite in-line with the arguments of [WIM 13]
who finds that performing, actively managed funds may experience alternated and
long periods of poor performance with no effective alpha, after several consecutive
years of successful investments. This may be the sign that performance may also
xxii Engineering Investment Process

come from an ability to time or take benefit from an identified economic cycle or
regime.

Moreover, it is not clear that every fund manager is shifting toward an active
management. [CRE 09] monitored through time the evolution of active shares of
funds from 1980 to 2003. Surprisingly, the proportion of active share shows a clear
decrease towards a lower active share. Among many figures, [CRE 09] identified in
2003 a percentage of assets under management with active share greater than 80%
was around only 23% in 2003. In 2016, the lack of active management is still
identified by the suite of proprietary SPIVA Scorecard reports delivered along the
years by S&P Dow Jones. The proportion of active funds is revealed to be very tiny,
less than 5% of funds in some countries. For instance, [UNG 15] identifies an inverse
link between the holding period of the fund and the ability of the best funds to remain
performing ones. A vast majority of funds (including in Europe or US) cannot
over-perform their benchmarks over the mid or long periods (typically 3, 5, or 10
years). In the 1980s, most of mutual funds were genuinely active: with more and
more available data, increased automated trading, more anomalies discovered, it may
seem paradoxical to observe that the proportion of indexed fund with passive
management has in fact increased since then. But it is quite natural to think that with
a low active management, there is little room for pure alpha generation. However as
[CRE 09] notes, the active bets of the mutual funds as a whole remains significant
when aggregated.

I.2.4.1. On the importance of factors

A sector index remains useful since it bears a true economic justification and
afterwards provides a coherent risk description. Sector investing may be therefore
conceived as a true investment possibility or mandate. Yet, the work of [BRI 15]
highlights the fact that factor investing is preferable to sector investing as long as
shorting is allowed and, in this context, it performs better than sector and
industry-based allocation both in bear and bull markets. However, with a
no-short-selling constraint, sector-based allocation gives better risk-return profiles in
both bear and bull periods (at least for US equities). Such a finding was already
underlined in [IDZ 13] whose work put some emphasis on the importance of the
short-selling possibility for factors to work well.

One cannot disentangle the profusion of (academic and empirical) work on

factors from the theoretical developments that started at the end of the 20th Century.
The original work of [FAM 92] was as the driver of a huge academic work in the
following two decades and indirectly irrigated a complete stream of business. The
core of their work was that they identified systematic, persistent and interpretable
sources of risk which could be qualified as persistent drivers of returns. The first two
explanatory factors they found were relative market-capitalization (“SMB” : Small
stocks Minus Big stocks). The second one was the book-to-market or value
component of stocks i.e. the comparison between the market value of the stock with
 Introduction xxiii

the accounting value of the company (“HML” : High book-to-market stocks Minus
Low book-to-market stocks). Some years later, a third factor was identified, namely
the momentum factor (see [JEG 93] and [CAR 97]). Value links future asset returns
with the long-term value of the company, proxied by the book (i.e. balance-sheet)
value of the company. Momentum links future asset returns with its recent relative
performance, often a one-year return, and emulates the trend propensity of the asset.
Others factors have been identified as in [PÁS 03] (the liquidity factor) or in
[FAM 15] which later extends the list of their identified factors.

All the aforementioned works aimed at identifying “anomalies” that are persistent
in the long-run and are a source of risk that is consistent and somewhat interpretable:
uncovering factors is satisfying when they bear a semantic interpretation that allows
us to tell a story to identify investment patterns and interpret performance realization.
Factors are for sure drivers of risk and...when they perform, drivers of returns. Factor
identification should originally be based to their risk explanation power, but the
success they encounter in practice or in the literature is paradoxically also linked to
their link with performance and their potential interpretability. It is clear that the
factors mentioned in the paragraph above have been present for a long time and that
their discovery did not affect their pertinence in risk decomposition.

Factors are generally understood within the same asset class. But even if those
factors were identified originally in the equity sphere, they may have a good
generalization as explained in [ASN 13]. The authors find that those factors are quite
universal across asset classes. They identify a common link through the channel of
liquidity risk that explain their correlation across markets and across asset classes.
They differ in the fact that value has a positive link, and momentum a negative link
with liquidity risk, explaining why those two factors are negatively correlated within
one asset class and one geographical market. The result holds for equities but also,
for instance, for government bonds, indices, commodities or currencies. Generally,
they are however expected to be mildly correlated within one asset class, but
empirically correlations rise during market downturns, becoming closer and closer to
one in the case of crisis. In conclusion, in addition to major macro risk factors like
inflation or economic conditions, those style factors are an overlay to understand
better the premium4 associated with long-run returns.

The factor representation allows us to identify bets of an active investor since any
performance track may be decomposed on those style factors. It became a clear
manner both to identify or classify active managers to understand to which category

4 There is still an ongoing discussion on the nature of potential anomalies, their remuneration,
their link with the potential risk they represent and the difference between risk premia with
behavioral anomalies. This is a deep question that we will not solve, yet we will give in section
4.4.5 some insights to at least shed some light on this fascinating yet difficult debate.
 List of Acronyms

Notations

a, b, ... scalars
a, b, ... column vectors
A, B, ... matrices
A′ or AT transpose of a matrix A
tr(A) trace of a matrix A
det(A) determinant of a matrix A
sign(x) vector of signs of components of x
∣φ∣ modulus of a vector φ associated with an AR process
IN N × N identity matrix
IN N × N matrix of ones
eN N-dimensional vector of ones
1 vector of ones, without precision on the dimension
t time
T total number of time observations
pi,t price of asset i at time t
diag(x1 , ..., xN ) denotes the N × N diagonal matrix of statistical objects
(x1 , . . . , xN ) on the diagonal, 0 elsewhere
Ri,t random variable of the return of asset i at time t
RM,t random variable of the return of the market at time t
Rt N -dimensional random vector of returns at time t
ri,t observed return of asset i at time t
RtP random variable of return of a portfolio p at time t
rtP observed return of a portfolio p at time t
rM,t observed return of the market M at time t
rf,t return of the risk-free asset at time t
rt N -dimensional vector of returns at time t
rk T -dimensional vector of returns for asset k
Another random document with
no related content on Scribd:
 ⅓ cup soft shortening
1 cup brown sugar
1½ cups black molasses

Stir in ...

½ cup cold water

Sift together and stir in ...

6 cups sifted GOLD MEDAL Flour

1 tsp. salt
1 tsp. allspice
1 tsp. ginger
1 tsp. cloves
1 tsp. cinnamon

Stir in ...

2 tsp. soda dissolved in 3 tbsp. cold water

Chill dough. Roll out very thick (½″). Cut with 2½″ round cutter. Place
far apart on lightly greased baking sheet. Bake until, when touched
lightly with finger, no imprint remains.
temperature: 350° (mod. oven).
time: Bake 15 to 18 min.
amount: 2⅔ doz. fat, puffy 2½″ cookies.

FROSTED GINGIES
Follow recipe above—and frost when cool with Simple White Icing
(recipe below).

SIMPLE WHITE ICING

Blend together 1 cup sifted confectioners’ sugar, ¼ tsp. salt, ½ tsp.
vanilla, and enough milk or water to make easy to spread (about 1½
 tbsp.). Part of icing may be
colored by adding a drop or two
of food coloring.

GINGERBREAD BOYS
Make holidays gayer than ever.
Follow recipe above—and mix in 1 more cup sifted GOLD MEDAL
Flour. Chill dough. Roll out very thick (½″). Grease cardboard
gingerbread boy pattern, place on the dough, and cut around it with
a sharp knife. Or use a gingerbread boy cutter. With a pancake
turner, carefully transfer gingerbread boys to lightly greased baking
sheet. Press raisins into dough for eyes, nose, mouth, and shoe and
cuff buttons. Use bits of candied cherries or red gum drops for coat
buttons; strips of citron for tie. Bake. Cool slightly, then carefully
remove from baking sheet. With white icing, make outlines for collar,
cuffs, belt, and shoes.
amount: About 12 Gingerbread Boys.

★ STONE JAR MOLASSES COOKIES

Crisp and brown ... without a bit of sugar.
Heat to boiling point ...

1 cup molasses

Remove from heat

Stir ...

½ cup shortening
 1 tsp. soda

Sift together and stir in ...

2¼ cups sifted GOLD MEDAL Flour

1¾ tsp. baking powder
1 tsp. salt
1½ tsp. ginger

Chill dough. Roll out very thin (¹⁄₁₆″). Cut into desired shapes. Bake
until, when touched lightly, no imprint remains. (Over-baking gives a
bitter taste.)
temperature: 350° (mod. oven).
time: Bake 5 to 7 min.
amount: About 6 doz. 2½″ cookies.

PATTERN FOR GINGER BREAD BOY

Trace on tissue paper. Then cut pattern from cardboard. Place
greased pattern on dough. Cut around it with a sharp knife. Other
cooky patterns can be made in same way.
To make “dancing” Gingerbread boys ... bend the legs and arms into
“action” positions when you place them on baking sheet (as shown in
small figures above).
Packing cookies successfully for mailing
1 Select heavy box, lined with waxed paper. Use plenty of filler
(crushed wrapping or tissue paper, or unbuttered popcorn or
Cheerios).
2 Wrap each cooky separately ... in waxed paper. Or place cookies
back-to-back in pairs ... then wrap each pair.
3 Pad bottom of box with filler.
Fit wrapped cookies into box
closely, in layers.
4 Use filler between layers to
prevent crushing of cookies.
5 Cover with paper doily, add
card, and pad top with crushed
paper. Pack tightly so contents
will not shake around.
6 Wrap box tightly with heavy
paper and cord. Address plainly
with permanent ink ... covering
address with Scotch tape or
colorless nail polish. Mark the
box plainly: “PERISHABLE.”
Festive Christmas Cookies
★ 1 Sandbakelser
★ 2 Spritz Rosettes
★ 3 Merry Christmas Cookies, Trees, Stars, etc.
★ 4 Nurnberger
★ 5 Almond Crescents
★ 6 Lebkuchen
★ 7 Scotch Shortbread
★ 8 Berliner Kranser
★ 9 Finska Kakor
★ 10 Russian Tea Cakes

Gay shapes ... for holiday cheer.

MERRY CHRISTMAS COOKIES ( Recipe)

Soft, cushiony cookies, dark or light.
DARK DOUGH.... For animal shapes, toy shapes, and boy and girl
figures.
Mix together thoroughly ...

⅓ cup soft shortening

⅓ cup brown sugar
1 egg
⅔ cup molasses

Sift together and stir in ...

2¾ cups sifted GOLD MEDAL Flour

1 tsp. soda
1 tsp. salt
 2 tsp. cinnamon
1 tsp. ginger

Chill dough. Roll out thick (¼″). Cut into desired shapes. Place 1″
apart on lightly greased baking sheet. Bake until, when touched
lightly with finger, no imprint remains. When cool, ice and decorate
as desired.
temperature: 375° (quick mod. oven).
time: Bake 8 to 10 min.
amount: About 5 doz. 2½″ cookies.

LIGHT DOUGH
For bells, stockings, stars, wreaths, etc.
Follow recipe for Dark Dough above except substitute honey for
molasses, and granulated sugar for brown. Use 1 tsp. vanilla in
place of cinnamon and ginger.

TO HANG ON CHRISTMAS TREE

Just loop a piece of green string and press ends into the dough at
the top of each cooky before baking. Bake with string-side down on
pan.

TO DECORATE
Use recipe for Decorating Icing (p. 31) (thin the icing for spreading).
For decorating ideas, see picture on preceding page. Sugar in
coarse granules for decorating is available at bakery supply houses.
STARS
 Cover with white icing. Sprinkle with sky blue sugar.
WREATHS
Cut with scalloped cutter ... using smaller
cutter for center. Cover with white icing.
Sprinkle with green sugar and decorate with clusters
of berries made of red icing—leaves of green icing—
to give the realistic effect of holly wreaths.
BELLS
Outline with red icing. Make clapper of red icing. (A
favorite with children.)
STOCKINGS
Sprinkle colored sugar on toes and heels before
baking. Or mark heels and toes of baked cookies
with icing of some contrasting color.
CHRISTMAS TREES
Spread with white icing ... then sprinkle with green sugar.
Decorate with silver dragées and tiny colored candies.
TOYS
(Drum, car, jack-in-the-box, etc.):
Outline shapes with white or colored icing.
ANIMALS
(Reindeer, camel, dog, kitten, etc.): Pipe icing
on animals to give effect of bridles, blankets,
etc.
BOYS AND GIRLS
Pipe figures with an icing to give desired effects:
eyes, noses, buttons, etc.

“Old country” Christmas treasures.

LEBKUCHEN ( Recipe)
The famous old-time German Christmas Honey Cakes.
Mix together and bring to a boil ...

½ cup honey
½ cup molasses

Cool thoroughly
Stir in ...

¾ cup brown sugar

1 egg
1 tbsp. lemon juice
1 tsp. grated lemon rind

Sift together and stir in ...

2¾ cups sifted GOLD MEDAL Flour

½ tsp. soda
1 tsp. cinnamon
1 tsp. cloves
1 tsp. allspice
1 tsp. nutmeg

Mix in ...

⅓ cup cut-up citron

⅓ cup chopped nuts

Chill dough overnight. Roll small amount at a time, keeping rest

chilled. Roll out ¼″ thick and cut into oblongs 1½ × 2½″. Place one
inch apart on greased baking sheet. Bake until when touched lightly
no imprint remains. While cookies bake, make Glazing Icing (recipe
below). Brush it over cookies the minute they are out of oven. Then
quickly remove from baking sheet. Cool and store to mellow.
temperature: 400° (mod. hot oven).
time: Bake 10 to 12 min.
amount: About 6 doz. 2″ × 3″ cookies.

GLAZING ICING
Boil together 1 cup sugar and ½ cup water until first indication of a
thread appears (230°). Remove from heat. Stir in ¼ cup
confectioners’ sugar and brush hot icing thinly over cookies. (When
icing gets sugary, reheat slightly, adding a little water until clear
again.)

★ NURNBERGER
Round, light-colored honey cakes from the famed old City of Toys.
Follow recipe above—except in place of honey and molasses use
1 cup honey; and reduce spices (using ¼ tsp. cloves, ½ tsp. allspice,
and ½ tsp. nutmeg ... with 1 tsp. cinnamon).
Roll out the chilled dough ¼″ thick. Cut into 2″ rounds. Place on
greased baking sheet. With fingers, round up cookies a bit toward
center. Press in blanched almond halves around the edge like petals
of a daisy. Use a round piece of citron for each center. Bake just until
set. Immediately brush with Glazing Icing (above). Remove from
baking sheet. Cool, and store to mellow.
amount: About 6 doz. 2½″ cookies.

TO “MELLOW” COOKIES
... store in an air-tight container for a few days. Add a cut orange or apple; but fruit
molds, so change it frequently.
ZUCKER HÜTCHEN (Little Sugar Hats)
From the collection of Christmas recipes by the Kohler Woman’s Club of Kohler,
Wisconsin.
Mix together thoroughly ...
 6 tbsp. soft butter
½ cup sugar
1 egg yolk

Stir in ...

2 tbsp. milk

Sift together and stir in ...

1⅜ cups sifted GOLD MEDAL Flour

½ tsp. baking powder
¼ tsp. salt

Mix in ...

¼ cup finely cut-up citron

Chill dough. Roll thin (⅛″). Cut into 2″ rounds. Heap 1 tsp. Meringue
Frosting (recipe below) in center of each round to make it look like
the crown of a hat. Place 1″ apart on greased baking sheet. Bake
until delicately browned.
temperature: 350° (mod. oven).
time: Bake 10 to 12 min.
amount: About 4 doz. 2″ cookies.

MERINGUE FROSTING
Beat 1 egg white until frothy. Beat in gradually 1½ cups sifted
confectioners’ sugar and beat until frosting holds its shape. Stir in ½
cup finely chopped blanched almonds.

Decorative favorites from lands afar.

SCOTCH SHORTBREAD
Old-time delicacy from Scotland ... crisp, thick, buttery.
Mix together thoroughly
...

1 cup soft butter

⅝ cup sugar (½ cup
plus 2 tbsp.)

Stir in ...

2½ cups sifted GOLD MEDAL Flour

Mix thoroughly with hands. Chill dough. Roll out ⅓ to ½″ thick. Cut
into fancy shapes (small leaves, ovals, squares, etc.). Flute edges if
desired by pinching between fingers as for pie crust. Place on
ungreased baking sheet. Bake. (The tops do not brown during
baking ... nor does shape of the cookies change.)
temperature: 300° (slow oven).
time: Bake 20 to 25 min.
amount: About 2 doz. 1″ × 1½″ cookies.

★ FINSKA KAKOR (Finnish Cakes)

Nut-studded butter strips from
Finland.
Mix together thoroughly ...

¾ cup soft butter

¼ cup sugar
1 tsp. almond flavoring

Stir in ...

2 cups sifted GOLD

MEDAL Flour
Mix thoroughly with hands. Chill dough. Roll out ¼″ thick. Cut into
strips 2½″ long and ¾″ wide. Brush tops lightly with 1 egg white,
slightly beaten. Sprinkle with mixture of 1 tbsp. sugar and ⅓ cup
finely chopped blanched almonds. Carefully transfer (several strips
at a time) to ungreased baking sheet. Bake just until cookies begin to
turn a very delicate golden brown.
temperature: 350° (mod. oven).
time: Bake 17 to 20 min.
amount: About 4 doz. 2½″ × ¾″ cookies.
SANDBAKELSER (Sand Tarts)
Fragile almond-flavored shells of
Swedish origin, made in copper molds
of varied designs.
Put through fine knife of food
grinder twice ...

*⅓ cup blanched almonds

*4 unblanched almonds

Mix in thoroughly ...

⅞ cup soft butter (1 cup

minus 2 tbsp.)
The ring of sleigh bells fills the air as
¾ cup sugar everyone races to church on Christmas Day
1 small egg white, in Finland.
unbeaten

Stir in ...

1¾ cups sifted GOLD MEDAL Flour

*In place of the almonds, you may use 1 tsp. vanilla flavoring and 1
tsp. almond flavoring.
Chill dough. Press dough into Sandbakels molds (or tiny fluted tart
forms) to coat inside. Place on ungreased baking sheet. Bake until
very delicately browned. Tap molds on table to loosen cookies and
turn them out of the molds.
temperature: 350° (mod. oven).
time: Bake 12 to 15 min.
amount: About 3 doz. cookies.
MOLDED COOKIES Mold ’em fast with
a fork or glass!

HOW TO MAKE MOLDED COOKIES (preliminary steps on pp. 14-

15)

1 With hands, roll dough 2 Flatten balls of dough 3 Cut pencil-thick strips
into balls or into long, with bottom of a glass ... and shape as directed
pencil-thick rolls, as dipped in flour (or with a ... as for Almond
indicated in recipe. damp cloth around it), or Crescents (p. 41) or
with a fork—crisscross. Berliner Kranser (p. 42).

DATE-OATMEAL COOKIES
Mix together thoroughly ...

¾ cup soft shortening (half butter)

1 cup brown sugar
2 eggs
3 tbsp. milk
1 tsp. vanilla

Sift together and stir in ...

2 cups sifted GOLD MEDAL Flour

¾ tsp. soda
1 tsp. salt

Stir in ...
 2 cups rolled oats
1½ cups cut-up dates
¾ cup chopped nuts

Chill dough. Roll into balls size of large walnuts. Place 3″ apart on
lightly greased baking sheet. Flatten (to ¼″) with bottom of glass
dipped in flour. Bake until lightly browned.
temperature: 375° (quick mod. oven).
time: Bake 10 to 12 min.
amount: About 4 doz. 2½″ cookies.

★ PEANUT BUTTER COOKIES ( Recipe)

Perfect for the Children’s Hour.
Mix together thoroughly ...

½ cup soft shortening (half butter)

½ cup peanut butter
½ cup sugar
½ cup brown sugar
1 egg

Sift together and stir in ...

1¼ cups sifted GOLD MEDAL Flour

½ tsp. baking powder
¾ tsp. soda
¼ tsp. salt

Chill dough. Roll into balls size of large walnuts. Place 3″ apart on
lightly greased baking sheet. Flatten with fork dipped in flour ...
crisscross. Bake until set ... but not hard.
temperature: 375° (quick mod. oven).
time: Bake 10 to 12 min.
amount: About 3 doz. 2½″ cookies.

HONEY PEANUT BUTTER COOKIES

Follow recipe above—except use only ¼
cup shortening, and in place of brown sugar
use ½ cup honey.

Sprightly tea cakes for friends and family.

THUMBPRINT COOKIES Nut-rich ... the thumb dents filled with

sparkling jelly.
I’m as delighted with this quaint addition to our cooky collection, from Ken
MacKenzie, as is the collector of old glass when a friend presents her with some
early thumbprint goblets.
Mix together thoroughly ...

½ cup soft shortening (half butter)

¼ cup brown sugar
1 egg yolk
½ tsp. vanilla

Sift together and stir in ...

1 cup sifted GOLD MEDAL Flour

¼ tsp. salt

Roll into 1″ balls. Dip in slightly beaten egg whites. Roll in finely
chopped nuts (¾ cup). Place about 1″ apart on ungreased baking
sheet. Bake 5 min. Remove from oven. Quickly press thumb gently
on top of each cooky. Return to oven and bake 8 min. longer. Cool.
Place in thumbprints a bit of chopped candied fruit, sparkling jelly, or
tinted confectioners’ sugar icing.
temperature: 375° (quick mod. oven).
time: Bake 5 min., then 8 min.
amount: About 2 doz. 1½″ cookies.

★ ENGLISH TEA CAKES Tender, flavorful tidbits with a sugary

glaze.
Mix together thoroughly ...

½ cup soft shortening (half butter)

¾ cup sugar
1 egg
3 tbsp. milk

Sift together and stir in ...

1¾ cups sifted GOLD MEDAL Flour

1½ tsp. baking powder
¼ tsp. salt

Mix in ...

½ cup finely cut sliced citron

½ cup currants or raisins, cut-up

Chill dough. Roll into balls the size of walnuts. Dip tops in slightly
beaten egg white, then sugar. Place sugared-side-up 2″ apart on
ungreased baking sheet. Bake until delicately browned. The balls
flatten some in baking and become glazed.
temperature: 400° (mod. hot oven).
time: Bake 12 to 15 min.
amount: About 3 doz. 1½″ cookies.

ALMOND CRESCENTS
Richly delicate, buttery. Party favorites.
Mix together thoroughly ...

1 cup soft shortening (half butter)

⅓ cup sugar
⅔ cup ground blanched almonds

Sift together and work in ...

1⅔ cups sifted GOLD MEDAL Flour

¼ tsp. salt

Chill dough. Roll with hands pencil-thick. Cut in 2½″ lengths. Form
into crescents on ungreased baking sheet. Bake until set ... not
brown. Cool on pan. While slightly warm, carefully dip in 1 cup
confectioners’ sugar and 1 tsp. cinnamon mixed.
temperature: 325° (slow mod. oven).
time: Bake 14 to 16 min.
amount: About 5 doz. 2½″ cookies.

LEMON SNOWDROPS
Refreshing, lemony ... with snowy icing.
Follow recipe for English Tea Cakes above—except use 2 tbsp.
lemon juice and 1 tbsp. water in place of the milk. Add 2 tsp. grated
lemon rind. Omit citron and currants. Mix in ½ cup chopped nuts.
Chill dough. Roll into balls and bake. Then roll in confectioners’
sugar.

BUTTER FINGERS
Nut-flavored, rich buttery party cookies.
Follow recipe for Almond Crescents—except in place of almonds use
black walnuts or other nuts, chopped. Cut into finger lengths and
bake. While still warm, roll in confectioners’ sugar. Cool, and roll in
the sugar again.
Festive cookies for the holidays ... ideal for Christmas boxes.