Time Machines for Investors
Investing is all about time traveling
April 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Investors are challenged when evaluating investment opportunities with limited track records
- Factor exposure analysis can be used to create replication portfolios
- These empower investors to walk backward and forward in time, enhancing the investment decision process
INTRODUCTION
Investing is all about time traveling. Most investors travel forward a few days, months, or even years, in order to take a snapshot of the landscape at that point in the future. They then travel back to the present time and position their portfolios accordingly. However, looking at the track record of these investors, which includes day traders, mutual fund managers, and global macro hedge funds, shows that time traveling is a treacherous business. The future they have seen was only one of an infinite number of universes.
A handful of investors have specialized in traveling forward for only extremely short time periods, less than a microsecond, studying the future order flows of other investors, mainly retail. These futures are more certain and can be exploited with high-frequency algorithms.
Another type of investor prefers to travel backward in time by simulating how strategies would have behaved historically. Using high-quality data sets and realistic assumptions, quants can determine the attractiveness of almost any strategy. Some have gone back centuries. Unfortunately, being able to travel backward in time does not guarantee that a strategy will also be profitable in the future.
One underrated form of time traveling in finance is via factor exposure analysis. This methodology has been used by investors primarily to explain the returns and risks of investment portfolios. However, it can also be used by investors to travel forward and backward in time, almost like a time machine, which we showcase in this research note (try Finominal’s Time Machine for recreating historical track records).
BASIC FACTOR EXPOSURE ANALYSIS
Investors have been using factor exposure analysis to explain the performance of investment portfolios for decades. The most common use case is to identify if a mutual fund manager has generated true alpha, or if his or her excess returns can be att
