The first question to answer is what is meant by quantitative analysis within fund management. A stock analyst or portfolio manager has a fairly defined role. For example, a stock analyst talks to companies, models the financial statements and makes judgements on a company’s future outlook. Strategists make judgements on the relative value of equities across sectors and markets.
So what is quant and what does a quant analyst do? In the early days a quant analyst was typically involved with questions such as performance attribution for funds. This gradually extended to looking at risk analysis. The quant analyst was often given the task of running models such as Barra to measure the portfolio’s tracking error against a benchmark. Within the asset allocation arena they were involved with running and understanding mean variance optimisers. The role of quants has extended further particularly in the past 10 years to stock selection and methods for screening stocks.
The role of a quant today, broadly speaking is to look at and have an input into all aspects of the fund management process. This can be divided into three main areas:
q stock selection;
q portfolio construction, and
q risk analysis.
Stock selection generally looks at methods of screening a list of stocks to produce an investable universe. Screens are often based on factors such as the value of the company, financial risk, size or liquidity and so on.
Portfolio construction is concerned with how those stocks are combined to create a portfolio with the required characteristics. For instance, a growth portfolio, value portfolio and so on.
Risk analysis looks at various characteristics of the portfolio such as its tracking error against the benchmark.
The US is regarded as the main area of innovation for quant research. From the 1950s outstanding academics such as Markowitz, Samuelson, Sharpe, Fama and Merton (to name just a few) developed a theoretical platform for portfolio management which was then adopted in practice. The growth of funds under management in the US and close links between academics and practitioners has promoted this continued development. Many of these ideas have then been taken up by managers globally.
Fund management has become more specialised in recent years. This partly reflects the influence of academic research as well as a maturing market in regions such as the US with ideas then being adopted globally. For example, work by academics such as Sharpe1 is widely attributed to the development of index funds designed to track index performance to a greater or lesser degree. The premise was that the market offers reasonable efficiency, therefore achieving active outperformance over an extended period is difficult and it is more efficient simply to track the market index. Fund managers such as BGI, State Street Global Advisors and Vanguard have built very successful businesses from this model and the growth in index funds has been phenomenal since the late 1970s. In practice, many active managers have struggled to outperform market indices, which has provided practical justification for indexation, particularly in the 1990s. This is necessarily a quantitative approach to fund management as optimisers are used to replicate an index and measure tracking error.
Other developments include the emergence of style based managers. The origins may be partly traced by to academic research. Fama and French2 have identified systematic bias in factor performance of value factors such as price to book value. Over time, other factors such as growth, analyst earnings revision and others were also shown to have biases that could be used to produce outperformance. This led to the growth of managers specialising in styles such as growth, value, small capital and so on, with the aim of exploiting inefficiencies through quantitative techniques.
More recently there has been growth of specialist funds in areas such as market-neutral investing where the manager buys one basket of stocks and sells another to capture stock-specific return while removing the effect of changes in the market. Often these approaches rely on quantitative techniques to help select the stocks to be long and short and to control the risk of the fund.
Market events and economic conditions have also promoted the growth in quantitative managers. The shift from a high to low inflation environment that was very pronounced in the 1990s made it difficult to add value through asset allocation as bonds and equity returns became more highly correlated. Therefore there was a move away from balanced funds into specialist equity and fixed income funds.
Market events such as the October 1987 “crash” led to a far greater concentration on risk analysis for portfolios. Other major market moves such as 1994, as a result of Fed tightening and a combination of the Russian crisis, Asia crisis and concerns over unwinding LTCM in the late 1990s have led managers to concentrate on the characteristics of the portfolio in terms of both investment style and risk. This relies to a large extent on quantitative analysis.
There are a number of external drivers promoting the use of quant research in Europe. One of these is the increased presence of asset consultants especially in wholesale funds management. Asset consultants generally work for fund trustees and one of their principal roles is to advise which fund managers the trustees should appoint to manage the money. To do this they need to be able to understand the process behind the fund managers’ decision. That is, how do managers select stocks, build the portfolio and control risk. If the investment process is ad hoc, then it is more difficult for consultants to determine whether they should appoint the manager. They are forced to rely on measures such as historical performance as a way of ascertaining how good the manager is. A fund may have exceptional performance as a result of a “star” portfolio manager. A good example is the exceptional performance of the Fidelity Magellan fund managed by Peter Lynch in the 1980s and early 1990s. There is academic evidence of persistence in mutual fund performance. However, if the ‘star’ decides to move or retire then future performance is more difficult to determine. As a result asset consultants tend to be more interested in a disciplined process that they can analyse and understand. This process is generally the product of quant research.
A further impetus for the acceptance of quantitative research is competitive pressure. Many US fund managers have established substantial operations in Europe. Examples include Putnam, Goldman Sachs, Merrill Lynch and Fidelity. These often have a process that involves a degree of quantitative input and is transparent and easily understood by asset consultants and clients. In a sense they have raised the benchmark by exposing clients to state-of-the-art techniques. Investment banks are also active in the promotion of quantitative techniques for funds management. For example, we have a team of over 50 quantitative analysts globally that look at new research ideas and discuss these with fund managers. We have developed risk models that show a fund’s exposure to economic factors as well as style analysis, stock selection techniques and other models such as implementation management. Competition in terms of performance comparisons has also driven managers to look at techniques that will provide an investment edge. Many of these are based on quantitative analysis.
The European experience with quant research further reflects other forces that can be considered cultural and historical. Just as the continent is a diverse mix of groups so is the use of quant research. Although reference to cultures often involves broad generalisations there does appear to be some patterns. For instance, the Dutch appear to have a very high absorption of quantitative research. Robeco is a good example, with a large and very sophisticated quantitative research group as well as running quantitative funds, as is ABP. This may partly reflect a long history in equities management as well as a cultural bias. A number of the institutions in Germany such as Allianz and Deka have a similar perspective. In the UK , again using generalisations, the attitude toward quant research appears to have been quite different, although there are signs that it is changing. The UK has the long history of equity investing. However the UK model has generally been to rely much more on bottom up stock selection and thematic overlays. Portfolio construction has resulted from the individual skill of the portfolio managers and risk analysis has often played little part.
In many areas of Europe the growth in equity investing is quite new. For instance, countries such as Italy, Spain, Portugal and Greece have a fairly young equity culture. Some of the Scandinavian countries have also only recently become active in equity management. Again, speaking very broadly it appears that these countries are eager to embrace quantitative techniques. This may be because there are few preconceptions and they have had the opportunity to look at best practice in areas such as America.
The overall conclusion is that the growth and adoption of quantitative analysis mirrors the increased sophistication of fund management generally as well as market and business factors. European managers are similar to their global counterparts in trying to develop a disciplined process for managing money which necessarily relies on some degree of quantitative input. This is elegantly stated by Grinold and Khan3: “The art of investing is evolving into the science of investing. This evolution has been happening slowly and will continue for some time. The direction is clear, the pace varies... This does not mean that heroic investment insights are a thing of the past. It means that managers will increasingly capture and apply those insights in a systematic fashion.”
Neill Brennan is head of European quantitative research at Schroder Salomon Smith Barney in London
1 Sharpe, W F, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk”, Journal of Finance Vol 19, September 1964, pp 425–442
2 Fama E F and French R K, “The Cross-Section of Expected Stock Returns”, Journal of Finance, Vol 47 June 1992
3 Grinold R C and Kahn R N, Active Portfolio Management (Richard D Irwin, 1995)