Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 334

What is quant investing and why is it different?

The essence of a quantitative investment approach is straight-forward: it is the utilisation of rational economic and fundamental investment insights in a disciplined and consistent fashion.

Of course, all investment managers use quantitative tools in various ways. Many use simple screens to help focus their detailed research on a smaller set of companies. This is especially important when managing global portfolios. The detailed research element often includes modelling a company's financial statements and company visits to gain a deep stock specific perspective. The final step is then to incorporate the research insight into portfolios to meet both risk and return objectives.

Investment styles move in and out of favour

One problem with this traditional approach is that no one investment style or theme is consistently rewarded. A better approach is to research and use a range of disciplines to determine which stocks to own or not. These range from longer-horizon, financial statements-based disciplines such as valuation, quality, sustainability and growth through to shorter-horizon strategies that aim to capture investor sentiment, company news and market events. Applying this breadth of insight is where a systematic quantitative approach is different to managers who take a fundamental focus on one dominant theme or philosophy.

Another key difference is a fundamental manager will examine the absolute depths of specific companies and industries, whereas a quantitative manager will work across a broader range of individual stocks and industries.

Quantitative managers undertake fundamental research upfront to formulate various investment ideas. These ideas are then tested with complex mathematical and statistical modelling to ensure that they are supported across different markets and investment environments.

Both are legitimate and credible means through which to approach investing and can have varying degrees of success depending on the point in the cycle.

Quant working alongside other investment styles

A quantitative approach can effectively work in tandem with other investing approaches in the one portfolio. A diversified quantitative approach can act as a scalable core exposure assisting with both capacity constraints and cost in other styles or managers.

The fact that the quantitative portfolio utilises a range of investment insights can also lead to improved after-tax outcomes. As the value manager sells his winners (realising a taxable gain) some of them may have become attractive to the growth manager. Inside the diversified quantitative portfolio, the same position simply transfers from the ‘value’ allocation to the ‘growth’ allocation without the need to realise the position.

While ‘off the shelf’ systematic strategies are growing in number, investors need to be careful to avoid inadvertently investing into potentially crowded trades or poorly-structured exposures with large unintended risk exposures. Using last year’s earnings relative to today’s price can often be a poor proxy for company valuation. A quantitative approach will model the financial statements of listed companies to derive a forecast of future earnings. This will include specific handling of accounting anomalies, country and industry effects.

Risk control is also critical as stock selection insight can often be drowned out by unintended portfolio bets caused by naïve approaches to portfolio construction, signal rebalancing and trading.

Quantitative managers are also well-equipped to manage the increasingly important area of sustainable investing, including a direct incorporation of ESG metrics. For some active managers, having an investor ask to invest in certain stocks or to avoid certain stocks while remaining tied to the benchmark can be problematic, but is less of an issue for quantitative managers with a view on every stock in the investment universe. They can make effective risk and return trade-offs even when required to exclude specific companies from their investment universe.

Valuations and performance

As with all investment disciplines, the performance of systematic quantitative investment strategies is largely influenced by the market and economic environment.

The post-GFC investment landscape has been dominated by central banks doing all in their power to meet growth and inflation targets. This monetary stimulus has fuelled risk appetite to the point where both equity and bond market valuations are stretched.

Price volatility has fallen as investor confidence has responded to the implicit view that monetary stimulus will always be applied by policy makers to mitigate downside events. This skewing of markets has been a difficult environment for active managers to outperform in.

In our experience, increases in uncertainty and volatility across financial markets makes the investor focus more on the fundamentals of the company they’re buying. This is usually when traditional active and active quantitative-style management is in a better position to outperform and offer investors the best possible return.

Outlook and examples

Diversification in investment insights is key. An investor focus on one particular style may not pay off. A robust quantitative approach can aggregate multiple investment disciplines in the one portfolio.

Looking ahead, there are opportunities for a valuation discipline to be rewarded but it’s skewed towards avoiding stocks that are expensive. Within the current economic cycle, there’s not a lot of cheap valuation opportunities available.

Valuation in some financial services stocks, such as the local major banks, is attractive, but whether earnings will contract from here, or exactly how they can grow earnings in the future, is unclear. The risk is though they are relatively cheap, they may be cheap for good reason. Any sensible investment approach must seek to discern between the value opportunity and the value trap.

A recent case in point is the turmoil which has engulfed AMP Limited (ASX:AMP). Since the start of 2018, the share price has more than halved from over $5 to below $2. Making sense of the company’s financial position has required a detailed investigation of a range of events and data. Our quantitative assessment was that AMP was unattractive on valuation grounds when trading at $5. The company’s interim and financial reports through 2018 and 2019 raised a number of flags, determining that the stock remained a value trap rather than an opportunity as its share price fell. Our analysis flagged events such as increases in cashflow volatility, uncertainty across the financial statements and analyst estimates.

Taking a simplistic approach such as a focus on reported earnings or past dividends paid could have led investors to view the stock as attractive as the share price fell. However, a quantitative approach can include complex and detailed rules with the added benefit of being unemotive in decision-making.

Another sector with a question mark is local discretionary retailers, who appear to be trading below reasonable valuations. Again, the risk for such firms is that if there’s any dislocation, such as any impediment to consumer spending, then they may be at risk of underperformance.

Overall, the combination of investment insight, risk-managed portfolio construction and manager oversight afforded by many quantitative managers serves to mitigate these uncertainties. 

 

Max Cappetta is Chief Executive Officer and Senior Portfolio Manager at Redpoint Investment Management. This information is of a general nature only and is not financial product advice. Opinions constitute our judgement at the time of issue and are subject to change, and do not consider the circumstances of any investor. 

 

RELATED ARTICLES

Five warnings about the most hated bull market in history

banner

Most viewed in recent weeks

Nest and nest egg: 23 aspects of housing and ageing

The family home is the biggest asset of most Australians across all age groups, and its role as both a place to live and an investment makes home ownership the biggest retirement policy issue.

20 favourite investment and life lesson quotes

Favourite quotations from famous people on markets, investing, processes, noise, pessimism, self perception and life balance. These lessons carry across investment cycles and lifetimes.   

Sorry, there’s no real place to hide

Billions of dollars of personal savings are flowing into 'fixed interest' funds, but do investors understand the risks? These funds have a place but they are not a short-term haven for worried retirees.

Media worth consuming - November 2019

Links to dozens of global media articles that often do not receive mainstream coverage in Australia. It's sceptical, fun and revealing, often challenging consensus and accepted wisdom.

We need national and personal visions for retirement

Two different articles cover a recent report on the attitudes of Australians towards retirement. What should be a enjoyable life stage is feared by many, and they fail to plan and work towards it.

How ‘residential for rent’ may change Australian housing

Australia has lagged many developed countries in providing top quality rental accommodation owned by institutions, but it is changing, driven by social preferences, affordability and investor needs.

Latest Updates

Investing

Millennials struggle to invest, but property top priority

The investment industry is looking for the best ways to engage with millennials. While younger people want to invest, they are either saving for a home or cannot afford to invest at the moment. 

Superannuation

Four major insights from APRA’s super heatmap

Check your fund on the heatmap. Many super trustees must decide whether to stick with their strategies or accept that APRA will take a tough approach to weeding out underperformers with high fees.

Superannuation

Checking the temperature of the APRA heatmap

The APRA MySuper heatmap uses a consistent methodology, and some funds come out badly. How will members and trustees react, and should APRA have sorted out the problems privately? 

Exchange traded products

Australian ETFs further widen their appeal

ETFs continue to increase strongly, especially in the fixed income category, with younger people and advisers among the major growth categories. Within a year, assets could hit $75 billion. 

Shares

A decade of Aussie shares: who delivered, who dithered?

Following the uncertainty of the GFC, 2010 to 2019 delivered decent Australian share results overall, with wide variations by sector. It's fascinating to see who won and lost over the decade.

Sponsors

Alliances

Special eBooks

Specially-selected collections of the best articles 

Read more

Pandora Archive

Firstlinks articles are collected in Pandora, Australia's national archive.

Read more