DEFINITION of 'Filter'
A filter is any form of criteria used to determine financial vehicles that can help to achieve investment objectives or fit within a specific investing style. Also referred to as screening, a filtering process often starts with a general set of parameters to eliminate companies that do not fit the investment style or objectives of an investor or portfolio manager. As the process continues, increasingly specific filters can be applied to define the financial vehicles that most closely match the optimal parameters for investment.
BREAKING DOWN 'Filter'
Filters are often used first to narrow the choices for investment by eliminating the companies, indices or financial vehicles that do not meet the broadest criteria for investment. For example, the first filter used by a portfolio manager of a large-cap dividend fund might be a screen that eliminates all small- and mid-cap companies from consideration. The second filter could be used to segregate all large-cap equities that do not pay dividends. As filters get more specific, they can be divided into two categories.
Valuation-based filtering processes typically focus on company fundamentals and the balance sheet, including free cash flow, revenues, earnings and debt-to-equity ratios. For example, the filters used by the manager of a large-cap dividend-paying fund might include a minimum for the current ratio of free cash flow to dividend payments, with the objective of subtracting companies from consideration that do not meet that benchmark.
A second filter could be implemented to subtract companies that fall below a benchmark for historic growth rates of free cash flow and dividend payments. In this type of process, portfolio managers continue to test companies against increasingly stringent filters until they make their final buying decisions.
Growth managers are more likely to use technical filters as a means of determining the companies with the highest potential to deliver returns. For example, a top-down manager might start the screening process with a broad-based filter such as sectors trading above their 200-day moving average. After eliminating the sectors trading below the moving average, a manager might set a filter for companies in the remaining sectors trading above their 10-week moving average.
As the number of companies that meet the parameters of each sequential filter narrows, the manager could set specific filters to find the companies trading with the highest levels of momentum. For example, a filter could be set to screen for companies in established uptrends with increasing volume. Much like with the valuation-based screening process, a growth manager could create as many technical filters as necessary to determine the companies that best fit the style and objectives of the portfolio.