Interpretation of High Z-scores in Quantitative Equity Strategies

Hard Active Equity Investing Quantitative Strategies

ABC Investment Management, a quantitative equity fund, has developed a systematic strategy focusing on stock selection based on a combination of fundamental metrics and price momentum. The strategy uses z-scores of various factors including earnings growth, price-to-earnings ratios, and relative price strength over the past twelve months to construct a portfolio of long positions in stocks expected to outperform the market.

Given this context, how should the fund manager interpret the significance of z-scores in the context of their strategy? Specifically, when deciding which stocks to include in the portfolio, what does a high z-score for a factor imply?

A high z-score indicates that the stock’s factor is significantly above the mean, suggesting it is overpriced relative to its peers.

A high z-score suggests that the stock's factor is performing well on a relative basis, indicating strength in that characteristic compared to other stocks.

A high z-score implies that the stock is highly volatile and should be avoided in the portfolio construction.

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