| Staying on top: the secrets to quant fund success |
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| 03/04/2005 | |
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Quantitative managers are increasingly found in the top quintile of the European fund performance tables. This is particularly true of tables showing risk-adjusted returns, or information ratios, which measure the return generated per unit of risk. By this measure, quantitative investment managers far outperform most other managers, as few traditional managers can consistently make the same claim over multiple performance periods. To be sure, this outstanding performance has not gone unnoticed. Most investment consultants highly recommend quantitative managers to their pension fund clients, and funds available to smaller investors are also seeing net inflows. The resulting unprecedented flow of assets into quantitative strategies has caused the majority of quantitative asset managers to close or consider closing strategies to further investments. But why have quantitative investors been so successful? To begin to understand the reasons, let's first highlight the main differences between quant managers and more traditional managers. Information overload With the advent of the technology boom and the Internet, information is everywhere. Fund managers are constantly bombarded with potential market-moving news. Company news is delivered via broadcast, print and online media, and sometimes directly from the company. A fund manager must assemble all this information and decide whether or not the new information may affect a company's share price and, if so, which direction the share price will move. The manager must also consider news that affects the economy or a particular company's sector, including potential litigation and geopolitical events. This amount of information is truly overwhelming. To help fund managers sort through it, the fund management community has embraced technology. In the past, traditional managers may have had access to company insights on key pieces of information affecting the firm's stock price. Today this level of information is available instantly over computer networks. In fact, companies that make selective information available only to key analysts are penalised severely. As a result of this situation, all fund managers—whether traditional or quant—have embraced advances in modern technology that help them process the vast amounts of information they receive. The main distinction between these two types of managers is the extent to which their firms have taken technology on board. Many institutional investors use quantitative tools, such as screens, to limit the amount of information they must process. However, these are generally not the managers you see at the top of the performance tables today. The managers at the top share at least one thing in common. They have made the distinct choice to spend capital on information technology and the people to support it, as opposed to hiring more people and investing in quantitative tools to assist them. This distinction is paramount. Technology steps in Running a truly quantitative firm is commonly thought to be a cheap way to enter the money management market. This is a big misconception. Many companies have gone halfway to quant and have not succeeded. The cost of acquiring the data necessary to drive a robust investment process and hiring the people to maintain and run the technology going forward is in fact not much different from staffing up a traditional investment firm. Further, company management must fully accept that technology is better equipped than the human mind to cope with vast amounts of information. Of course it is true that, so far, a computer is not capable of generating new ideas on its own. For that, firms must invest in the people and the resources to help drive the process. And this is exactly what successful quantitative firms have done. They have fully embraced technology and research to help their fund managers avoid the dangers of information overload, such as an overreaction to news that is of no importance or an under-reaction to important news. They also realise that technology can help remove fund managers' cognitive biases – a fancy term for people doing the wrong thing based on past experiences. Quantitative managers know human behaviours are flawed. They accept that the quantitative process forces them to act in a way that may conflict with their instincts. This happens systematically, and that is one of the most important reasons why quantitative mangers perform so well. When traditional managers are presented with the same information as quantitative managers, they cannot process it in a systematic fashion. That's because the human mind is emotional, while a systematic quant process is not. A quantitative process will force the manager to sell or buy a stock, day in and day out. Of course, the process will occasionally choose the wrong time to buy or sell, but even a 55% success rate can lead to table-topping performance. A question of capacity How many times have we seen enormously successful traditional managers boasting a fantastic track record gather assets at unprecedented speed only to lose those assets at the same pace a few years later? Without naming names, we all recognise this familiar scenario. It is a phenomenon driven by the herd instinct that consultants and investors exhibit when allocating assets. That instinct is governed by a fear of missing what appears to be a free lunch. Of course, it is not really a free lunch. After all, asset managers are in the business of growing assets and increasing the average fee charged for managing those assets. This is the case both for quantitative managers and traditional managers. However, quantitative managers have a distinct advantage in that they can recognise, and are motivated to act on, capacity constraints. This is because the classic quantitative strategy is based on a portfolio of diversified securities with measured predictive powers, portfolio characteristics, and trading impact. As a result, the inherent chipping away of risk-adjusted performance associated with a growing asset base is easily observed. In this respect, quantitative managers are very similar to hedge funds, which routinely close to new investments once they have reached a certain size. Yet, why do we not often see traditional fund managers closing funds? While greed surely plays a role, these firms also greatly underestimate the rising level of risk that comes with investment success. Because they invest in people rather than technology, traditional managers do not fully appreciate the problems inherent in escalating a successful investment strategy with a low asset base into a large scale operation with each individual holding carrying a substantial liquidity risk. For instance, it is not unusual for a traditional investment manager to hold up to 10% or more of the outstanding capital of any single company. While the investment theses that caused them to invest in the company may be correct, the holding carries an unprecedented stock-specific risk making it vulnerable to company-specific events. Current examples include insurance companies being investigated in the US and cases of accounting irregularities at European companies such as Parmalat and Ahold. Whereas quantitative fund managers may have been invested in any one of these names, their stake would have been manageable enough to get out without demanding a huge liquidity premium for doing so. In fact, it is often difficult to spot quantitative investors among the registered holders of European shares. This is because their portfolios are typically very liquid and their holding periods are limited. In fact, quantitative strategies lend themselves to determining capacity limits and the level at which the strategy should close. Through the privilege of technology and data availability, quantitative managers can estimate the loss of information ratios related to a growing asset base. They can run historical simulations that can accurately forecast the loss in returns and the additional liquidity risk they would need to accept to be a credible player. This is indeed one of the reasons why quantitative managers have and should continue to have a real performance advantage over their more traditional counterparts. Where do quantitative managers go from here? As long as quantitative managers do not become complacent, greedy, or disseminate their technological advantage to the marketplace too broadly, this alternative investment niche remains in great shape to service an increasingly demanding customer base. But, quantitative firms must also continue to innovate new technologies that help them become stronger, better and faster. The most financially rewarding avenue of technological advance is surely natural language processing. In the past, quantitative processes have been unable to deal with the written word. Although it has been possible to interpret simple text strings with quantitative tools, technology is now available to interpret and quantify analyst reports and verbal broadcasting in numerous languages. This is the focus of serious quantitative managers today. Yet, it demands an enormous upfront investment in technology and people. And, while a successful solution will not emerge fully until the medium to long term, quantitative firms that are serious about their philosophy and their clients' investment returns cannot sit on the fence. They must make the financial commitment in technology and people to ensure the future of their strategy. Susanne Willumsen is vice president for State Street Global Advisors' active equity strategy in the UK. |
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