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

Dividend investors, your turn is coming

Why valuation multiples fail in an exponential world

Five reasons why Tesla is the everything bubble

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

House prices surge but falls are common and coming

We tend to forget that house prices often fall. Direct lending controls are more effective than rate rises because macroprudential limits affect the volume of money for housing leaving business rates untouched.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

100 Aussies: five charts on who earns, pays and owns

Any policy decision needs to recognise who is affected by a change. It pays to check the data on who pays taxes, who owns assets and who earns the income to ensure an equitable and efficient outcome.

Three good comments from the pension asset test article

With articles on the pensions assets test read about 40,000 times, 3,500 survey responses and thousands of comments, there was a lot of great reader participation. A few comments added extra insights.

The sorry saga of housing affordability and ownership

It is hard to think of any area of widespread public concern where the same policies have been pursued for so long, in the face of such incontrovertible evidence that they have failed to achieve their objectives.

Latest Updates

Superannuation

The 'Contrast Principle' used by super fund test failures

Rather than compare results against APRA's benchmark, large super funds which failed the YFYS performance test are using another measure such as a CPI+ target, with more favourable results to show their members.

Property

RBA switched rate priority on house prices versus jobs

RBA Governor, Philip Lowe, says that surging house prices are not as important as full employment, but a previous Governor, Glenn Stevens, had other priorities, putting the "elevated level of house prices" first.

Investment strategies

Disruptive innovation and the Tesla valuation debate

Two prominent fund managers with strongly opposing views and techniques. Cathie Wood thinks Tesla is going to US$3,000, Rob Arnott says it's already a bubble at US$750. They debate valuing growth and disruption.

Shares

4 key materials for batteries and 9 companies that will benefit

Four key materials are required for battery production as we head towards 30X the number of electric cars. It opens exciting opportunities for Australian companies as the country aims to become a regional hub.

Shares

Why valuation multiples fail in an exponential world

Estimating the value of a company based on a multiple of earnings is a common investment analysis technique, but it is often useless. Multiples do a poor job of valuing the best growth businesses, like Microsoft.

Shares

Five value chains driving the ‘transition winners’

The ability to adapt to change makes a company more likely to sustain today’s profitability. There are five value chains plus a focus on cashflow and asset growth that the 'transition winners' are adopting.

Superannuation

Halving super drawdowns helps wealthy retirees most

At the start of COVID, the Government allowed early access to super, but in a strange twist, others were permitted to leave money in tax-advantaged super for another year. It helped the wealthy and should not be repeated.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.