Top 400 Asset Managers: Will the quants strike back?
Fabio Cecutto argues that a simpler quant manager could be a smarter quant manager.
In an paper written in January 2008, ‘Quant Management at an Inflection Point’, we painted a cautious view on equity 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 – with asset growth from less than $10bn (€7.78bn) in 2004 to over $50bn by 2008, according to GMO – in broadly similar strategies, thereby reducing the attractiveness of the opportunity set.
Now, while we have a positive view of some strategies, we 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.
Equity quants have experienced a roller-coaster ride over the past 10 years. Throughout the middle of the last decade, life was good: 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.
Extreme market events, such as the ‘quant crunch’ during the summer of 2007, were caused by crowding. 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 crowding.
The ‘risk-on’, ‘risk-off’ macro-led market environment of the past few years has been challenging for active equity strategies, whether quantitative or fundamental. Two investment styles in particular faced headwinds in this environment – value and momentum. As the two styles are expected to be complementary, the theory is that a combined approach should generate smoother returns. This had been the case for many years. However, when both styles underperform there are few places for a quant to hide, particularly if clients are expecting the strategy to add value over the short to medium term. It is no coincidence that recent style headwinds in value and momentum coincided with negative performance for some quantitative managers (see figure on page 8).
In a challenging environment, many quantitative managers decided they had to change their approach significantly to maintain a competitive edge. By and large, these efforts have focused on three areas – uniqueness of insights, style-timing and more judgemental input.
• Unique insights: to avoid the issues resulting from the crowding of factors, quantitative managers have worked hard to identify unique insights. Some managers sought newer, differentiated data sources or worked to build proprietary signals, leveraging less exploited relationships between data and expected returns;
• Style timing: this has been at the top of the research agenda. Quantitative managers have increasingly attempted to make use of dynamic risk/return frameworks that adapt to changes in equity market leadership;
• 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.
Not all innovation has resulted in improvements. While still anchored around traditional factors, quantitative equity strategies have become increasingly heterogeneous and complicated, which has raised the bar when assessing these strategies. However, we believe a few quantitative managers are ahead of their competitors and can demonstrate credible differentiation in their approach. We look for a variety of attributes in a manager.
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 than to react to events.
It is important that managers complement robust historical studies with a pragmatic and intuitive understanding of markets. For example, we think 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.
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 model’s overall risk budget.
Everything else being equal, a modest level of assets under management is an advantage. Our view is that it is easier to deliver alpha with total assets of $1bn than it is with, say, $20bn. This is particularly true for higher portfolio turnover approaches that use factors with a short time horizon for potential added value.
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.
We do not believe that traditional quantitative factors have been permanently arbitraged away. We expect the well-documented behavioural phenomena behind these factors, such as the premium associated with basic valuation ratios, to recur over the long term and provide opportunities for patient investors. Market innovation is making quantitative investing more commoditised. This may present challenges for some types of active manager.
However, for the asset owners, this trend is good news. Systematic equity exposures can increasingly be accessed through cost-effective and transparent investment strategies, leading to improvements in overall investment efficiency. We have long been advocates of such solutions – which we call smart beta – that bridge the gap between passive and traditional active approaches.
Index providers and passive managers have so far been at the forefront of the smart beta trend. There is now a widening range of indices and products that offer alternatives to the default market-cap weighted index. Of course, some of the caveats that apply to quants also apply to systematic smart beta approaches. Indeed we believe that traditional quantitative managers have a role to play within smart beta, given their extensive experience of the practicalities of quantitative investing.
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 overly complicated if they are well-grounded and available at reasonable fees. A smarter quant could be a simpler quant.
Fabio Cecutto is senior investment consultant at Towers Watson