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Quantitative investing –

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 inflows were significant, 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 Watson’s 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 Markowitz’s 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 five-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

Source: eVestment, Towers Watson

Increase in quantitatively-managed assets 5 Assets (US$ billion) 70 60 50 40 30 20 10 0 2004 2005 2006 2007 Source: GMO The trend is not always a quant’s friend The ‘risk-on’.. Our concern was primarily driven by the significant increase in assets. by definition. were caused by crowding – in other words. when both styles underperform there are few places for a quant to hide. before the financial crisis. we painted a cautious view on quants. few quantitative managers used valuation spreads to assess the attractiveness of value. too many assets chasing the same return factors. the theory is that a combined approach should generate smoother returns. relying largely on historical information to forecast risk and return. For example. We discussed our views on value in a recent article. often leveraged.6 Momentum is a trend-based investment style that struggles at major market inflection points (as. As the two styles are expected to be complementary. Even fewer had developed indicators to monitor crowdedness. particularly if the strategy is expected to add value over the short to medium term. it lags behind changes in market leadership). ‘Quant management at an inflection point’.” 2 Quantitative investing – will quants strike back? towerswatson. ‘risk-off’ macro-led market environment seen over the past few years has been challenging for active equity strategies. Extreme market events. thereby reducing the attractiveness of the opportunity set. 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. Two investment styles in particular faced headwinds in this environment: value and momentum.. were not well-suited to capture the systemic risks created by these crowded trades.it “ is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers. However. Relative rolling five-year performance of value and momentum 7 Return (US$. Towers Watson “. Figure 03. managed using quantitative strategies. This had been the case for many years.What happened? Too many assets In our January 2008 article.com . pa) 20% 15% 10% 5% 0% -5% -10% 1998 2000 2002 2004 2006 2008 2010 2012  Momentum  Value Source: Style Research Ltd. Figure 02. Quantitative approaches. whether quantitative or fundamental. As Figure 03 suggests. it is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers. such as the ‘quant crunch’ during the summer of 2007. Many quants use momentum to add diversification to their often value-biased approaches.

US$20 billion. say. For example. Some of the key things we look for are: Suitable fees Fees for quants are often too high for the likely level of value added. Pragmatic market awareness It is important that managers complement robust historical studies with a pragmatic and intuitive understanding of markets. 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. But this reduces transparency and can make it more difficult to confirm competitive advantage. differentiated data sources or worked to build proprietary signals. Finally. Some managers sought newer. and style inflection points are very difficult to predict with accuracy. in fact. However. What we look for in quants Not all innovation has resulted in improvements. Many quantitative managers decided they had to change their approaches significantly. Quantitative managers have increasingly attempted to make use of dynamic risk/return frameworks that adapt to changes in equity market leadership. quantitative managers have worked hard to identify unique insights.. quants have had to face a challenging environment. inevitably impairing their effectiveness. even when we see more differentiated factors. leveraging less exploited relationships between data and expected returns. Such factors are. They know that quantitative tools may introduce discipline but are not inherently better than traditional. •• Judgemental input – Some managers have decided to broaden their risk/return framework by adding macro-based signals or to rely more on fundamental or thematic judgement to compensate for the limitations of their quantitative models. style-timing and more judgemental input. Data mining can also be an issue as ever-growing swathes of data series are scrutinised. these efforts have focused on three areas: uniqueness of insights. Low assets Everything else being equal. they frequently do not account for a significant part of the quantitative model’s overall risk budget. In order to prolong its competitive advantage. period-specific and we have observed a number of these processes struggle when used in real-life scenarios. Our view remains that it is easier to deliver alpha with total assets of US$1 billion than it is with.” towerswatson. •• Style timing – Style-timing has been at the top of the research agenda. a manager may become more secretive. quantitative equity strategies have become increasingly heterogeneous and complicated. Some managers also develop products with very low active risk in order to optimise gross information ratios of the strategy. Introspection The best quant managers are highly reflective and well aware of the natural shortcomings in quantitative approaches. •• Unique insights – To avoid the issues resulting from the crowding of factors. a modest level of assets under management is an advantage. that some style-timing indicators may have long-term signalling power. Whilst still relying on traditional factors. rarely unique. We see similar insights spreading rapidly across the quantitative investment community.com Quantitative investing – will quants strike back? 3 . These managers are more likely to foresee problems rather than react to events. we think “. in order to maintain a competitive edge. Factor differentiation We are cautious of managers claiming an edge through the exploitation of ‘unique’ factors. subjective methods. Back-tests of style rotation indicators are. effectively ignoring the real-world drag from fees paid by clients. This has raised the bar for asset owners and consultants when seeking to understand and assess these strategies.quantitative “ equity strategies have become increasingly heterogeneous and complicated.. by definition. we believe there are a few quantitative managers that are ahead of their competitors and can demonstrate credible differentiation in their approach. many managers are required to deliver alpha over the shorter term.All change please Over the past five years. By and large. However. This is particularly true for higher portfolio turnover approaches which use factors with a short time horizon for potential added value.

TW-EU-2013-30601. we offer solutions in the areas of employee benefit programmes. June 1992 or Jegadeesh. Towers Watson is a leading global professional services company that helps organisations improve performance through effective people. value: highest quintile by earnings yield. towerswatson. we believe that quantitative investing can still play a useful. ‘Portfolio selection’. and takes no account of subsequent developments after that date. With 14. for the asset owners. The Journal of Finance. transparent and easily-implementable investment strategies. However. Systematic equity exposures can increasingly be accessed through cost-effective. 5 U  S$ value of coincident holdings. such as the premium associated with basic valuation ratios. Copyright © 2013 Towers Watson. this trend is good news. There is now a widening range of indices and products that offer alternatives to the default market-cap weighted index. January 2013.com . financial and risk management. past performance is not indicative of future results.000 associates around the world. The Journal of Finance. given their extensive experience of the practicalities of quantitative investing. but probably a good one’. ‘The cross-section of expected stock returns’. Market innovation is making quantitative investing more commoditised. 6 ‘ Value investing – an old idea. and expanded. 2005. Towers Watson and its affiliates and their respective directors. This document may not be reproduced or distributed to any other party. March 2013. Nonetheless. some of the caveats that apply to quants also apply to systematic smart beta approaches. Towers Watson. to recur over the long term and provide opportunities for patient investors. In particular. In the absence of its express written permission to the contrary. or Fabio Cecutto +44 20 7227 2378 fabio. The Journal of Finance. role in portfolios via greater use of smart beta strategies.cecutto@towerswatson. March 1952. As such. except as may be required by law. We have long been advocates of such solutions – which we call smart beta – that bridge the gap between passive and traditional active approaches. legal. Conclusion Following disappointing performance from some products. To achieve this. tax or other professional advice or recommendations of any kind. This document is based on information available to Towers Watson at the date of issue. 7 S  imulated performance of selected strategies. This may present challenges for some types of active manager. leading to improvements in overall investment efficiency. its contents are not intended by Towers Watson to be construed as the provision of investment. A smarter quant could be a simpler quant. Quirk & Associates. 4 A  verage relative returns of representative active global or international equity strategies from 10 large quantitative managers.com Notes: 1 H  arry Markowitz. quarterly rebalance. Performance is relative to stated strategy benchmark. 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. whether in whole or in part. market-cap weighted. Casey. Indeed we believe that traditional quantitative managers have a role to play within smart beta. Disclaimer This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. French. Index providers and passive managers have so far been at the forefront of the smart beta trend. without Towers Watson’s prior written permission. as taken from 13F filings in US. gross of fees. talent and reward programmes. of the largest eight quantitative-only investment managers. accounting. Universe: Largest 2500 global companies in global universe. and risk and capital management. innovation rarely remains unique for long and process enhancements often lead to greater complexity. 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. or to form the basis of any decision to do or to refrain from doing anything. traditional active quantitative equity investing is now far less popular. All rights reserved. Despite efforts by managers to differentiate themselves. 3 F  or example. Titman.The rise of smart beta We do not subscribe to the belief that traditional quantitative factors have been permanently arbitraged away. but remain cautious on this group as a whole. 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. 2 F  or example: Fama. Further information For further information please contact your usual Towers Watson consultant. ‘The geeks shall inherit the Earth?’. Manager selection based on assets managed in active quantitative-only strategies. ‘Returns to buying winners and selling losers: Implications for stock market efficiency’. 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. momentum: highest quintile by 12 months price momentum. March 1993. In addition. Of course. We expect the well-documented behavioural phenomena behind these factors. We have a positive view of some strategies. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties.