Research is a critical component in the pursuit of alpha and the highest resource area of the firm. Currently, Los Angeles Capital has over 20 professionals dedicated to equity research and technology/system support, not including personnel in Portfolio Management and Trading. Key research areas are reviewed below:
Watch Director Emeritus of Research Dave Borger discuss Elements of the Dynamic Alpha Model.
Los Angeles Capital's approach to equity management is based upon the concept of Investor Preference Theory®. Therefore, the primary objective of the research team is to identify risk characteristics in the market that investors are presently pricing, with the goal of revealing investor preferences over time. These preferences are then expressed as expected factor returns. Once the Research Department identifies factors that the market considers relevant, the next task is to measure and analyze these factors appropriately. Some of the factors capture traditional measures of style, size, and quality, while others are more specialized. As investors' understanding of the equity market evolves and as the market itself changes, Los Angeles Capital's commitment is to find new factors that increasingly explain equity performance.
The research team monitors three information sources to better understand the types of information investors believe to be important: (1) Wall Street and vendor research, (2) academic research, and (3) private equity research. Wall Street research, both quantitative and traditional fundamental research, remains the best source for understanding what institutional and retail investors find valuable. Academic research helps keep the firm abreast of new valuation techniques, while following the private equity markets helps the firm better understand new corporate strategies for increasing value to shareholders.
In order to facilitate factor research, Los Angeles Capital has developed proprietary data databases and signals which incorporate information from leading data providers. Researchers then have the ability to analyze individual factors as well as a factor's contribution to existing models. Los Angeles Capital maintains a significant IT Department supporting this data and research effort.
Watch Brad Rowe, CFA discuss Factor Selection in Quantitative Equity.
Los Angeles Capital utilizes a wide variety of statistical tools to properly measure factor returns and to distinguish between true signals and noise. The techniques that the firm uses are the result of over 30 years of modeling financial data - the last 13 years specifically applied to Los Angeles Capital's Dynamic Alpha Stock Selection Model®. Much of the ongoing research is devoted to incorporating state-of-the-art statistical methodologies into the estimation techniques, and customizing these for specific data characteristics and model applications. The main goal of the statistical research is to more accurately identify the forward looking price of each investment risk.
Unlike other quantitative investment managers, Los Angeles Capital does not weight factors based on their historical explanatory power, nor does the firm assume that factors will “mean revert” to their historical averages. Rather than following “laws of nature,” the price of risk reflects investor attitudes, opinions or preferences in the current market environment based primarily upon today’s unique set of conditions. Los Angeles Capital resists the temptation of optimizing factor weights to historical time periods (the most common weakness of most quantitative products) but, instead, embraces a dynamic forward-looking view.
Los Angeles Capital's research efforts have also supported the firm's trading desk. This effort has led to the development of proprietary, real-time trading algorithms which have decreased trading costs and increased overall trading capacity. Additionally, the firm has garnered more control over the entire trading process, from order submission to trade execution. Research’s objective is to help develop and fine-tune proprietary trading algorithms to trade stocks at the lowest possible costs.
Watch Stuart Matsuda discuss Los Angeles Capital's Trading Function.
Software and systems development are essential components in building a successful quantitative investment process. At Los Angeles Capital, there is substantial migration between classical research and information technology, both in terms of projects and personnel. The Research Department and the IT team are collectively involved in the development of software projects while maintaining a high level of quality control.
Many firms use risk management tools as part of their process. Very few have been building them for more than 30 years and use them in such an integral way as Los Angeles Capital. Indeed, given that the firm’s investment process begins with an analysis of how investors are pricing risk at any point in time, it is important to be able to develop current estimates of market volatility in order to construct portfolios that both adhere to the client’s level of risk tolerance and optimally trade future performance against return volatility. By combining alpha forecasts for over 9,000 global equity securities with estimates of risk in global equity markets, the firm’s optimization process identifies buy and sell candidates that improve the portfolio’s expected Information or Sharpe Ratio consistent with established client guidelines. Portfolio changes are a reflection of the most recent return estimates generated by Los Angeles Capital's Dynamic Alpha Stock Selection Model® in conjunction with up-to-date estimates of risk. Rebalances occur in a cost sensitive manner and employ current estimates of market impact in order to control the cost of portfolio turnover.
Managing returns or risk in the rear view mirror frequently leads to undesirable results. Understanding and recognizing that no active management process works in every possible environment will lead to better and more stable investment outcomes. As such, the portfolio construction and risk management process seeks to understand both changing return opportunities and levels of risks within the market when trading risk against return in the target portfolio. In addition, the risk management process aims to make efficient use of the available risk budget by spending risk on value add factors, while simultaneously avoiding risks that are not priced, during the construction of investment portfolios.
Watch Ed Rackham, PhD discuss Integrating Risk Management Into the Investment Process.