Factor Construction with Different Lookbacks

Does the lookback matter for stock selection?

September 2024. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Intuitively quant strategies should benefit from new information and shorter lookbacks
  • However, fundamental-based factors improve from longer lookbacks given more robust signals
  • Less relevant for price-based factors like momentum or low volatility

INTRODUCTION

The world is a complex system that never stands still and continuously evolves, which makes investing interesting but also challenging. Companies have to change each day to survive in the brutally competitive economy. Most active fund managers have chosen to play along and prioritize the latest quarterly earnings over the long-term outlook of companies.

However, when running quantitative strategies this short-term focus is questionable. Naturally, there are some short-term-oriented trading strategies focused on earnings and news, but most focus on companies’ fundamentals or stock price patterns over the medium to long term. Quants want robustness, which requires reducing false signals, e.g. Tesla having one great quarter does not necessarily make it a great company. Given this, stocks are typically selected by looking at fundamentals that stretch back one year or longer.

In this research article, we will review the impact of the lookback period of factor portfolio construction.

VALUE FACTOR CASE STUDY

We focus on five factors in this analysis, namely momentum, value, quality, low volatility, and growth, which are defined in line with industry standards. The investible universe is defined as all stocks in the U.S. with a market capitalization of more than $1 billion. We construct factor portfolios by selecting the top and bottom 10% of stocks ranked by the factor metrics, which are then rebalanced monthly with a transaction cost of 0.10%.

Value stocks are selected based on a combination of price-to-book and price-to-earnings, where we vary the lookback for these metrics between one and five years. Given quarterly earnings, this means four updates for book equity and earnings when using one year, and twenty when using five years. Naturally, the market capitalization of stocks changes daily, so even without fundamental updates, the metrics for each stock will change at the monthly rebalancing (read