About two years ago I dove deep into Quantopian and quantitative finance. I had done a fair bit of research on long term historical returns data and published this on my blog: engineeredportfolio.com. In that research, I found that the sectors of consumer staples and health care performed surprisingly well. And so did midcap value.
I had a pretty simple idea to look at the returns of companies that were both in those sectors and in that style/size. I then added some letter grade filtering based on Morningstar stock grades to make sure the companies were not terrible. Lastly, I wanted this to be something that I could trade with my own (small) account so I wanted to have a) not too many trades and b) not too many companies to spread my small amount of capital across.
What I found was a surprisingly well performing "index" of 5 stocks with the following requirements:
- Consumer staples, health care, packaging, or restaurants
- Mid or small cap value
- Financial, growth, and profitable grades of C or above
- Sort remaining ~15 companies by market cap and rebalance to middle 5
- More explanation on the theory here: Engineering an Index Fund
Do this monthly and watch out! There was over a 10% annual outperformance with a total return of over 2,000%. So I decided to live trade it with real money (back in the day when Quantopian let you connect to brokerages). For a while, it was working beautifully! But then I learned a couple hard lessons:
- 5 stocks are too few, especially when you don't have great conviction about them. When 1 has a bad earnings report the whole account sees massive volatility
- On a related note, tracking error is hard to stomach. Having so few stocks that are so specific to a certain style and sector causes you to be grossly uncorrelated to benchmarks. This is hard to keep your conviction when most accounts are going up and you're hopping up and down all over the place
- Past performance doesn't predict future returns. It's an obvious one yet I had convinced myself that I found the golden egg! I was wrong... there may be something to some of the logic I applied but it won't work cleanly and consistently enough to keep investors engaged and committed, myself included.
Quantopian eventually shut down the live trading which thankfully forced me to look for simpler rules based trading approaches which ended up leading me to "accelerating dual momentum" which continues to go well (and it's simple!).
