You’ve surely read my post with 2022 trading results.
There I mentioned the most important achievement of the year: the development and practical application of a small-cap strategy. In this article, I’d like to tell you more about what it is, how it was developed, what historical results have been achieved, including the 2008 crisis; and how you can get access to the model.
Here is a chart and excerpt from the article in case you missed it:
Important: always subtract the return of the index from the return of the securities portfolio to filter the average market direction and determine your potential return. When the index shows its average return after some time (+6.3% GAGR for Russell since 2008), the strategy should generate approximately 0.291+0.063 = 0.331 or +33.1% CAGR in the long run.
Broker’s report: here.
How the model was developed
I’ve been interested in securities for a very long time, and over the years I’ve learnt several key ideas from various sources:
- There are people who systematically beat the securities indexes.
- The vast majority of these people are retail investors with relatively small accounts in the several million dollar range.
- Large funds are not good at investing in small companies because their volumes have a strong impact on the price.
- Small companies have the highest volatility of fundamental factors and the highest correlation between positive reports and performance.
- There is a small capitalization premium in passive indexes.
- Buffett made the most profit in the first decades because according to him: the size of his assets was small and it was a very big advantage.
Even half of this information would be enough to make it obvious that it is necessary to ignore large and even medium-sized capitalizations and to completely focus efforts on small and even micro-capitalizations.
With the help of good friends in the data field, over a few months we built and tested a model based on the classic VALUE and GROWTH factors, no price action, just good old reports. Most of the factors were taken from William O’Neil’s book How to Make Money in Stocks, as well as a lot of inspiration came from the works by O’Shaughnessy. It’s not that I’m particularly inclined toward people of Irish ancestry – it’s just a coincidence 😊
After creating the first version of the model, we could immediately see that there was a steady small positive return, but only in small-cap securities. And the smaller the capitalization and liquidity, the larger and more stable the premium obtained over the index.
But there was also bad news – if the position volume is too large, our market impact would negatively affect the performance. With our volumes, we’ll push the price up on entry and down on exit – against us.
There was only one little thing left to do – improve the model and exclude completely illiquid securities because even a volume of several hundred dollars per day can have a significant negative impact on the price.
Results of the work
The second half of 2021 was spent actively improving the model, and in the end we got this:
The scale is logarithmic (on a standard linear scale it’s just a lovely exponent but nothing is clear).
Some visual deterioration of the blue line is caused by the 2022 recession (the decline of the red line). The model always makes less money when the indexes fall. To compensate for this effect, I subtract the red line of the index returns from the blue line of the strategy returns and get the green line Excess Returns. The green line is not perfect, but as mentioned at the beginning of the article, it filters the market modes well.
Important: the strategy was almost not optimized in any way, and as for the fundamental factors, we should understand as clearly as possible where they come from, what they mean, and how they work. This was done to avoid over-optimization of the model parameters as much as possible. An over-optimized model shows excellent results in history but breaks down immediately as soon as you apply it to real trading.
The model takes into account poor execution prices, triple IB transaction costs and has a high capital intensity. The most important rule in developing any strategy is that there are no ideal conditions.
Also, we achieved this profitability on a non-margin CASH account with only 90% cash loaded (with 10% spare unused cash most of the time) so it is compatible with retirement accounts. On top of that, it’s absolutely safe to use 1.25x leverage on a margin account and regulate excessive risks through shorting the index and get 1.3x profitability.
The strategy is constantly being improved and all the changes are implemented after getting results on real money accounts on the out-of-sample period.
How to get access to the model
Starting in 2023, all students who completed the integrated strategy course will have access to a monthly updated list of tickers and recommendations on how to work with it correctly. I’ll explain how to buy/sell tickers with minimal market impact and maximum capital intensity, how to work on small and large accounts, how to rebalance correctly, and how to work with margin funds.
Join us, there’s plenty of room for everyone! If you have any questions, please contact me via contacts and I will be happy to answer your questions. I wish you all successful trading!
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