Numeric Investors' momentum investing strategy and scaling challenges

Numeric Investors

In the case study, Numeric Investors was begun with intention of providing the public, with an above average return through: what was known as momentum investing. Simply put this when, the company would seek out those stocks that were having earnings momentum, which could help to increase the value of the portfolio. This was based off a computer model using the Apple II GS to identify changes in the underlying equity security. However, this idea was taken one step further, by identifying those companies that are having negative earnings momentum. At which point, managers could engage in a short position (this is where they want the price of the stock to decline) so that they can produce a larger overall return. The results were that this strategy provided the Numeric Investors, with a formula that could outperform the S & P. 500 and all of the major market averages. Over the course of time, this meant that they began to become popular with a host of institutional and affluent individual investors (who were seeking out their services). Where, the firm was advertised based off of: referrals and word of mouth to generate new business. This helped to increase the total amount of: money under management and it meant that number of portfolios they were offering expanded. As this basic philosophy of playing both sides of the market, would be reflected in numerous strategies they were utilizing to include: momentum, value and momentum / value. The idea with this kind of investing was, to have fund managers identify changes in the number of securities using: the computer model and monitoring the earnings reports (prior to the opening of the markets). This was a part of the strategy to keep the majority of assets invested in the equity markets, to maintain the high returns. At the same time, this was designed to help sustain low transaction costs, as the firm was able to use their influence and the large number of orders they were executing to negotiate a low commission rate. Yet, beneath the surface the underlying success of the portfolios and the amount of money they were gathering, meant that maintaining this kind of strategy would difficult to maintain. As the company could leave large amounts of cash sitting on the sidelines and they had a limited number of portfolios (based on the earnings momentum in possible long / short positions). This is problematic, because it meant that Numeric Investors would have to change from their basic investing strategy moving forward. To fully understand the overall challenges that the company is facing requires examining the strategies that are being utilized. This will be accomplished through: looking at the actual investment strategy, the long / short strategy, the earnings momentum strategy, the value strategy, how they monitor / control transaction costs and if the decision to close their new investment products (to shareholders) was prudent. Together, these different elements will provide the greatest insights as to the underlying challenges that Numeric Investors is facing moving forward. ("Numeric Investors," 1997)

Numeric's Investment Strategy

The basic investment strategy that is being utilized, by Numeric Investors is one that is focused on increasing the overall return through: the purchase of long and short positions. This philosophy allows the computer models, to identify those companies that have the possibility of seeing the most extreme earnings momentum (either positive or negative).

As a part of this strategy a number of different considerations that must be taken into account to include: margin requirements, the size of the liquidity buffer, trading requirements, management fees, taxes, better returns, potential exposure to double risks and the use of a bottom up strategy. Margin is when the company has to borrow existing shares to short the stock. This means that with every single short position they are going to be using, must be on margin. This is problematic, because margin is also considered to be a loan from the brokerage firm. Where, they will extend to the company a certain amount of credit to purchase the stock. This can be challenging, if the company has a surprise positive earnings announcement that occurs. As it could cause the price of the stock to: rise exponentially without having any kind way to limit the downside in the losses. At which point, the firm can begin receiving margin calls, because the position has lost some value However, this is necessary in order to conduct any kind of effective shorting. To protect against this kind of uncertainty, the company has enough trades to prevent against any kind of sudden margin calls, from adverse changes in the price of shorted positions. Trading requirements are specified guidelines that will identify, what qualifies as part of the portfolio on the long and short side. Where, the company has specific situations for determining changes in earnings momentum. Management fees are when Numeric Investors will pay managers a percentage of the fees for: analyzing and conducting trades in the portfolio. Taxes could have an impact upon the portfolio, by causing the overall amounts of capital gains to remain high (due to the short-term nature of the trading). Better returns are when, the company would use the computer model to identity those stock that are the best candidates. This is then, augmented with the experience of portfolio managers to take advantage of anomalies that are occurring. The potential exposure to double risks is when the company could have their short and long positions move against them at the same time. At which point, the potential losses increase and some kind of action must be taken to mitigate them. The use of the bottom up strategy is designed, to provide the portfolio with those stocks that are seeing either: sharply increasing or decreasing earnings. These different elements are important, because they are highlighting the underlying risks of using this investment strategy and the potential rewards. ("Numeric Investors," 1997)

The Long / Short Strategy

The long / short strategy that Numeric Investors is using is to hold a combination of both kinds of positions simultaneously (regardless of changes in the market conditions). As the firm, is using the different long positions, to identify those companies that are being to experience upward earnings momentum. At which point, they will purchase the investment for its potential price appreciation over the short to medium term time frames. While the short positions, are used to find those stocks that have begun to: see earnings momentum peak and exploit what is happening. This is important, because it shows how Numeric Investors strategy, would help them to take advantage of any kind changes that were taking place in the market. As they could benefit from playing both sides, which is helping to increase their returns (regardless of the general trends in the averages). ("Numeric Investors," 1997)

Double Alpha

The double alpha strategy is when Numeric Investors would take their long / short positions and then balance them against the major market averages. The idea was to reduce the overall amounts of underlying risks, while increasing the total return. However, this strategy increased the possibilities that the long positions will outperform any of the short positions in the portfolio. Once this occurred, it meant that the return could be reduced by holding on to the long positions to long. As this strategy was concerting on mirroring the different benchmarks for the long positions, while not addressing possible risks that could affect the shorts. This is important, because it shows how the underlying investment strategy would continue to evolve, based upon the desire to increase the overall return as much as possible. ("Numeric Investors," 1997)

The Earnings Momentum Strategy

The earning momentum strategy is designed to find those companies that are beginning to see changes in their earnings. This is because the majority of investors will more than likely focus on analysts' forecasts and remaining to close company estimates. This is problematic, because it means that investors and traders will tend to under react in the stock. Where, the philosophy that is used by Numeric Investors can spot when changes that are taking place in the momentum of the company early. At which point, they can either go: long or short and then ride the stock all the way up / down. Once this occurs, it means that the overall return is greater, by taking advantage of the different anomalies. ("Numeric Investors," 1997)

The Value Strategy

Over the years, Numeric Investors also discovered that many of different momentum and value orientated stocks moved in a similar fashion. As the strategy could identify what specific stocks would be the best candidates to realize the projected price targets, while ignoring companies that might not be based on any kind of fundamentals (such as: select biotechnology companies). This would help portfolio managers to identify stocks that were more volatile than their underlying fundamentals. At which point, they could determine those companies that have the possibility of seeing increasing or decreasing earnings. Where, managers would look at the correlation of the stock over time and traditional valuation models. This helped to improve their analysis of the company and find those stocks that would outperform the major market averages. ("Numeric Investors," 1997)

How They Monitor and Control Transaction Costs

In general, most investors could be able to purchase some kind of stock index funds or index futures to mirror the same kind of results. To improve the overall return, meant that Numeric Investors would have to control their underlying transaction costs as much as possible. This was accomplished through negating with brokers to narrow the underlying spread between: the bid and ask prices for the stock. Where, the company was receiving a substantial discount in comparison with other firms and investors. This helps to control costs and monitor the overall amount of transactions that they are conducting. However, the success of this strategy has meant that the underlying transaction costs have been increasing, because of the larger blocks of stock that are being purchased (which will have an impact on the execution price). To receive a more favorable return, the company has allowed transaction costs to increase on some trades, so that they can receive the best execution price possible. ("Numeric Investors," 1997)

Is the Decision to close the Firm to new Investment Products Prudent?

The decision to close the firm to new investment products was not prudent. This is because the firm had identified numerous strategies that could play both sides of the market. Where, they were limiting their portfolios, as they are tying up more of investment capital by: purchasing the stock long and short. If Numeric Investors had opened themselves up to new ideas that could augment their current strategies with new ones. This would create new portfolios that would reduce the underlying amounts of risk that they are facing in the markets. For example, if company executives had kept an open mind, they would have discovered that they could use this same philosophy with other investment articles. Where, they could have reduced the underlying risks, by using put options that would mirror the movement of the underlying stock. While at the same time, they could have purchased the long positions outright or call options. This would mean that the company could execute the trades for the actual stock on those positions that are moving towards their profit objectives. This would free up the overall amount of: investment capital and it will give the company greater choices, as to how they can achieve their underlying profit objectives. As a result, this is important, because it shows how the ability to close itself to: new financial products and tools would cause the company to market themselves to a limited number of investors. ("Numeric Investors," 1997)

The ideal amount of money under management for the firm would be between: $300 billion and $800 billion. This is because, the current strategy is limiting the overall amounts of capital that they have under management. If they can increase this number, they have the possibility of being able to: reduce their trading expenses and they could offer investor numerous portfolios following the same basic model. The difference is that it would be augmented with other tools to help: reduce risk and increase the overall returns. Once this occurs, it means that Numeric Investors can be able to reach out to shareholders, by offering unique products that are focused on the fundamentals and momentum of the stock. At which point, the firm will have more influence in being able to: reduce expenses and increase the overall return that they are providing. ("Numeric Investors," 1997)

Clearly, the biggest challenge that Numeric Investors is facing going forward is: that they closed their investment products to new shareholders. This is problematic, because it is placing a cap on the overall amount of money that they have under management and it is limiting the strategies that they are using to increase the overall return. As they are focused mainly on: achieving these objectives through: the valuation and momentum-based computer model. At which point, they will have managers identify various anomalies that are occurring. While this basic philosophy has proven to be successful, the fact of the matter is that numerous investment tools could be utilized to: reduce the underlying amounts of risk, increase the overall return and allow the company to purchase other positions (such as: using options in conjunction with the underlying strategy). This is troublesome, because it is limiting the returns and tools that managers have at their disposal to achieve this objective. At the same time, the inability to increase the number of products and assets under management means that the company is marketing to a limited number of investors. Given the increasing competition in the sector, will cause the company to see a loss of the assets under management. As host of different firms will begin to use other tools that Numeric Investors' portfolio managers' may not have at their disposal. As a result, the company needs to refocus on increasing the total amount of assets that they have under management and the various tools that they are using to reduce risk / increase the overall return. This means that they need to create new products based on: the basic valuation and momentum philosophies that are incorporated with the latest tools into their strategy. This will help to reduce their trading costs and it will increase the number of positions that the company is holding. Once this takes place, it means that Numeric Investors can offer a unique product to a host of different investors around the world.