Stock Selection/Dynamic Alpha Model

Los Angeles Capital Management's Dynamic Alpha Model is the method by which alpha estimates are generated weekly for over 6,000 global securities.  It employs a factor-based approach, rigorously measuring and analyzing over 45 variables that L.A. Capital believes are important to investors as they buy and sell securities.  Six-month forecasts are created based on each factor’s velocity, momentum, and statistical significance.  Through this process the signal is determined, if any, that each factor is generating and the confidence in that signal.  There is no bias or preconception of what that signal should be nor is it forced to be zero if it is negative. It is accepted that investors understand how and why a factor is priced, based on their appetite for risk.  Once the signal is determined for each factor, then each stock’s exposure to that factor is considered.  Stock scores are a function of exposures to each factor multiplied by the forecast.  Because of the strict adherence to the above process, the criteria for selecting stocks are systematic and comprehensive.  However, since the Dynamic Alpha model is adaptive, it does not have the same difficulty at inflection points that static quantitative models face.

Performance attribution shows that 70% of the alpha generated over the past 8 years has come from fundamental factors (income statement, balance sheet, and market) and 30% from sector factors.  Our approach to sector management is unique in that a sector represents one component of a stock’s return.  In other words, sector classification is treated as a risk factor in a similar fashion to the fundamental factors mentioned above.

Since the intellectual foundation for our investment process, Investor Preference Theory, states that investor preferences are subject to change and new factors may be emerging at any time, we recognize the importance of capturing new drivers of return.  Thus it is necessary to understand new themes that may be in their infancy today.  Research ideas are prioritized and assignments are reviewed each quarter.  Research findings and recommendations for changes are presented to the Investment Committee by our head of research, Dave Borger.  All changes must be unanimously approved.  When new factor ideas do not meet all of the requirements, the factor behavior still continues to be monitored and/or explore new ways to measure the factors.