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will quants strike back? Quantitative equity managers (quants) have experienced a roller-coaster ride in the past 10 years. Throughout the middle of the last decade, life was good for quants: performance was strong, asset inows were signicant, and even fundamental managers were embracing the merits of quantitative tools in screening and portfolio construction. Today, however, investors often exclude quants from their agenda.
What went wrong? How has the industry reacted? What is Towers Watsons current view on this group of asset managers? In this thought piece, we answer these questions and suggest what opportunities may lie ahead for quantitative approaches. The early 2000s changed the scene. Having gone through the dot-com bubble unscathed, quant strategies gained widespread legitimacy, becoming popular with investors and attracting dramatic growth in assets on the back of strong returns.3 Strategies employing leverage were particularly successful. Many fundamental managers adapted their processes to make greater use of quantitative insights. The end for traditional fundamental approaches seemed nigh. But the history of financial markets is replete with humbled investors and the extraordinary success enjoyed by quantitative strategies proved to be short-lived. Many quantitative managers have performed poorly (see Figure 01) and just as strong performance led to strong inflows, the opposite has also come to pass. Quantitative investing is, for many today, out of fashion.
Quants on a roller-coaster
Quants, who use systematic factor-based models to analyse and invest using widely available data, have a long history in equity management. Financial market historians ascribe the beginning of quantitative investment strategies to Harry Markowitzs seminal work on portfolio theory in 1952. 1 From a few early adopters, quants slowly found their place as providers of niche investment approaches alongside traditional fundamental managers. Much of that popularity stems from the growing support of finance academics.2
Figure 01. Relative rolling ve-year performance of a representative group of large active quants 4
Return (US$, pa) 6% 4% 2% 0% -2% -4% -6% 2007 2008 2009 2010 2011 2012
What happened?
Too many assets
In our January 2008 article, Quant management at an inflection point, we painted a cautious view on quants. Our concern was primarily driven by the significant increase in assets, often leveraged, managed using quantitative strategies. We felt that structurally low barriers to entry and prolonged favourable market conditions had encouraged excessive asset gathering (see Figure 02) in broadly similar strategies, thereby reducing the attractiveness of the opportunity set. Extreme market events, such as the quant crunch during the summer of 2007, were caused by crowding in other words, too many assets chasing the same return factors. Quantitative approaches, relying largely on historical information to forecast risk and return, were not well-suited to capture the systemic risks created by these crowded trades. For example, before the financial crisis, few quantitative managers used valuation spreads to assess the attractiveness of value. Even fewer had developed indicators to monitor crowdedness.
Source: GMO
Momentum Value
Source: Style Research Ltd, Towers Watson
...it is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers.
2 Quantitative investing will quants strike back? towerswatson.com
that some style-timing indicators may have long-term signalling power. However, many managers are required to deliver alpha over the shorter term, and style inflection points are very difficult to predict with accuracy. Back-tests of style rotation indicators are, by definition, period-specific and we have observed a number of these processes struggle when used in real-life scenarios.
Factor differentiation
We are cautious of managers claiming an edge through the exploitation of unique factors. Such factors are, in fact, rarely unique. We see similar insights spreading rapidly across the quantitative investment community, inevitably impairing their effectiveness. In order to prolong its competitive advantage, a manager may become more secretive. But this reduces transparency and can make it more difficult to confirm competitive advantage. Data mining can also be an issue as ever-growing swathes of data series are scrutinised. Finally, even when we see more differentiated factors, they frequently do not account for a significant part of the quantitative models overall risk budget.
Low assets
Everything else being equal, a modest level of assets under management is an advantage. Our view remains that it is easier to deliver alpha with total assets of US$1 billion than it is with, say, US$20 billion. This is particularly true for higher portfolio turnover approaches which use factors with a short time horizon for potential added value.
Suitable fees
Fees for quants are often too high for the likely level of value added. Managers often have over-optimistic assumptions about the future information ratio (the ratio of relative return per unit of relative risk taken) of their strategies. Some managers also develop products with very low active risk in order to optimise gross information ratios of the strategy, effectively ignoring the real-world drag from fees paid by clients.
Introspection
The best quant managers are highly reflective and well aware of the natural shortcomings in quantitative approaches. They know that quantitative tools may introduce discipline but are not inherently better than traditional, subjective methods. These managers are more likely to foresee problems rather than react to events.
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Conclusion
Following disappointing performance from some products, traditional active quantitative equity investing is now far less popular. We have a positive view of some strategies, but remain cautious on this group as a whole. Despite efforts by managers to differentiate themselves, innovation rarely remains unique for long and process enhancements often lead to greater complexity. Nonetheless, we believe that quantitative investing can still play a useful, and expanded, role in portfolios via greater use of smart beta strategies. Asset owners can use systematic strategies to target style exposures inexpensively and in a way that is consistent with their beliefs or portfolio construction needs. To achieve this, it may not be necessary for quantitative approaches to use unique inputs or to be very complicated if they are well-grounded and available at reasonable fees. A smarter quant could be a simpler quant.
Further information
For further information please contact your usual Towers Watson consultant, or
Fabio Cecutto
+44 20 7227 2378 fabio.cecutto@towerswatson.com
Notes:
1 H arry Markowitz. Portfolio selection. The Journal of Finance, March 1952. 2 F or example: Fama, French. The cross-section of expected stock returns. The Journal of Finance, June 1992 or Jegadeesh, Titman. Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of Finance, March 1993. 3 F or example, Casey, Quirk & Associates. The geeks shall inherit the Earth?, 2005. 4 A verage relative returns of representative active global or international equity strategies from 10 large quantitative managers. Manager selection based on assets managed in active quantitative-only strategies. Performance is relative to stated strategy benchmark, gross of fees. 5 U S$ value of coincident holdings, as taken from 13F filings in US, of the largest eight quantitative-only investment managers.
Disclaimer This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watsons prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. Copyright 2013 Towers Watson. All rights reserved. TW-EU-2013-30601. March 2013.
6 Value investing an old idea, but probably a good one, Towers Watson, January 2013. 7 S imulated performance of selected strategies; momentum: highest quintile by 12 months price momentum; value: highest quintile by earnings yield. Universe: Largest 2500 global companies in global universe, market-cap weighted, quarterly rebalance.
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