by Greg Bright
Two conflicting trends are emerging in investment management which contrast fundamental top-down research with quantitative data sourcing, analysis and management. Forget the index versus active debate, it’s looking more like politics versus big data and artificial intelligence.
Quantitative analysis could be at an interesting point of its evolution. On the one hand, technological developments mean that quants have an increasing array of tools and data to work with in their assessment of stocks and other investments. On the other hand, geopolitical shifts have meant fundamental managers are of increasing importance to understand the changing world in which companies and the providers of other securities operate. Both trends are seismic. The impact of the technology trend will probably be with us for a long time and so, sadly, may the political trend.
For the world’s largest quant managers, though, the collision between fundamental and quant because of these seismic shifts is not something investors should be concerned about, they say. Both BlackRock and State Street Global Advisors (SSGA) believe that quant investing, certainly as those two firms have practised it, has always included fundamental assessments. It has never been the black box rear-view-mirror management that it has sometimes been portrayed.
This view is supported by Morningstar Investment Management, which acquired the quant-oriented Intech Investment Consulting in Australia in the 2000s which was merged with its American Ibbotson Associates subsidiary. Daniel Needham, one of Intech’s bright young things, is now the global CIO of Morningstar.
According to Olivia Engel, Boston-based senior managing director and CIO of active quantitative equity at SSGA, quant investing can mean different things to different people. From her perspective, there are three main ‘pillars’ which drive the active quant space. They are:
- the “active” part is because it’s the relentless pursuit of alpha via various opportunities around the globe
- the “quant” part is because it exploits the full breadth of thousands of companies around the world, which quantitative analyses allows you to do, and
- importantly, it starts with an investment idea or some economic rationale – “this part is really important” – and it doesn’t really differ from any other investment style.
She says: “An example of the idea might be: How do we capture the rise of intangibles in company value? We are actually looking to codify fundamental investment ideas and then apply them across the whole market, instead of on an individual company basis.”
She says that any investment idea has to make “sense”. SSGA incorporates intangibles as well as it can and also looks at the sustainability attributes of the companies it invests in for clients. “That’s what active quant means to us,” Engel says.
BlackRock’s Isabelle Mateos y Lago, the firm’s London-based chief multi-asset strategist and a member of the BlackRock Investment Institute, which develops thought leadership on macro and actionable market views, says the firm uses a big “toolkit” in the development of its investment strategies.
“I’m not a quant myself but I understand the benefits they bring to any strategy,” she says. “It’s the blend of the two that’s important.”
One of BlackRock’s tools in its toolkit is the ‘BlackRock Geopolitical Risk Indicator’, which was developed with exactly the idea in mind to provide quantitative analyses to political and policy-related global shifts. The current trade war, if it’s a full-scale war, between the US and mainly China, is a classic example of a potentially long-term economic challenge which will have its winners and its losers.
Mateos y Lago says that the fundamental analysts have a “healthy scepticism of any quant approach. “There’s always the risk of a ‘black box’, even with a huge amount of theory behind it,” she says.
Of course, there is nothing wrong with a black box if it always works. The problem is that the ‘black’ part means that people outside the quant team, such as client super funds, are not given all the information they need to draw their own conclusions. For smaller investors, even if they had the information they are unlikely to be able to assess it.
“Quant investment has never been judgement free,” she says. “We have never turned over the keys to the machine.” Investors caught in the 1987 ‘portfolio insurance’ strategies in that year’s stock market crash, may dispute that. But BlackRock, nor the constituent managers it subsequently purchased, such as Merrill Lynch Investment Management and Barclays Global Investors, did not offer that strategy.
According to Peter Bull, Morningstar Australia’s head of equities and portfolio manager, who has a long history of research in his native America as well as Australia, says that geopolitical considerations have always been there.
“Quants had a big wake-up call with the GFC. No-one holds themselves out to being a pure quant manager anymore,” he says. “To me, quants are like Google Maps. If you don’t know where you are going, you are just going to spin the wheels.”
The wake-up call was actually before the GFC. It happened over a bizarre period in August 2007 where most, if not all, quant managers suffered a substantial drop in performance numbers and sudden outflows. The blame is generally laid on the weight of money in certain global macro quant strategies. But, the strategies largely ‘corrected’ themselves within a fortnight, or in some way adjusted to the situation, and by the end of the month most investors had survived the mini-crisis reasonably well. Bull recalls, though, that some quant managers suffered irreparable business damage.
He adds that that experience and some current factor investing strategies being used by investors could be perceived as “investment nihilism”. He says: “It’s like saying ‘momentum is cheap’ – it doesn’t mean anything.” By that he means that all factors and strategies tend to run in cycles, and weight of money tends to shorten those cycles.
Bull says that benchmark-relative investing is often “over-engineering”. He says: “You have to ask yourself whether it’s worth it. You invariably get to [assessing]shorter time horizons. If it’s cost effective and the client want then, okay.
In a recent paper by the CFA Institute Research Foundation called ‘The Current State of Quant Equity Investing’, it is argued that the current approaches and products of quant equity investing “stand on the shoulders” of major theoretical and empirical contributions in financial economics. It’s all about risk and return.
The paper provides and interesting historical perspective on the development of quant styles, at least for equities, which includes a discussion of various persistent anomalies that have led to the current toward factor investing.
It’s conclusion is that quant equity management is “alive and well” and “intellectually active” as investors seek to better manage risk and return.
The paper, written by Ying L. Becker and Marc R. Reinganum, says: “Factor investing has taken off commercially in the form of smart beta products and strategies, vetted by decades of prior and current research. Dynamic factor-timing approaches are probably still in the early stages, especially from a commercial perspective. However, one might reasonably forecast this to be a growth area for the quantitative equity field.
“A new generation of big data approaches is developing in the field and will likely grow as technology becomes more capable and more data are digitally available. Quantitative equity management techniques are helping investors achieve more efficient and appropriate investment outcomes.”
SSGA’s Olivia Engel says that an individual’s brain is probably more of a black box than a quant model. “In terms of the origins of the ideas on which our models are built, they are 100 per cent intuitive and have strong economic rationale,” she says.
She believes that markets tend to react to political decisions and change when there is not much expectation beforehand. “We think a better way to manage risks is to prepare for them all the time.” Different risks need different sorts of portfolios. For instance, real assets are good to counter inflation risk and utilities are good in an economic downturn – rather than prepare for one scenario, we should manage for many.
She says she does not know, however, how anyone can position an equity portfolio for anything as catastrophic as a nuclear war. The portfolio would probably be the least of our worries in such a time.