Recent market turmoil has sparked a lively debate about the merits of so-called quant managers. Critics assert the quants were caught off-guard by the credit crisis that began last summer as their investment models appeared to fail them. Since global credit markets began to seize up last July, there have been several periods when quantitative techniques worked perversely. That is, at times, stocks with low valuations, strong earnings estimates and good momentum — all attributes of winning stocks over the long pull — have lagged badly behind stocks with the opposite characteristics. As a result, some say the quants' best days might be behind them in this more volatile climate where market trends are far from clear.
Typically, the debate is framed in the context of managers that use a quantitatively based process vs. managers that use a traditional fundamental process. In my view, this is an artificial divide that tends to obscure the important point of what constitutes excellence in an investment management approach regardless of the label pinned on it.
Consider computer technology; every manager uses it to some degree. Traditional managers typically use quantitative screens to narrow down their universe of stocks and rank likely returns. Good quant managers, however, don't depend on a black box for their investment decisions. They use many of the same tools that fundamental managers use but in a very systematic and disciplined way.
The fundamental characteristics that determine stock returns — principally valuation, earnings potential, financial quality and price movements — are very much part of the quant methodology. Quants are also quite capable of adding an experienced-based, judgmental element into the mix in times of extremes.
There is no doubt that a structured approach is essential to take advantage of opportunities in this increasingly complex investment world. Research has shown that the human brain can keep track of no more than seven or eight changing parameters at one time in its decision-making. How, without the help of technology, can it absorb the changes — in fundamental stock attributes, risk characteristics and security prices — that affect a global universe of 25,000 or so stocks that an excellent manager might have available for active portfolio selection?
Structure and discipline, though, do not imply rigidity. Take research on what drives security returns, which is, or should be, an integral part of every manager's process. Analysis of past data clearly matters, but the ability to bring fresh ideas to the table is what differentiates a good manager from the average. Quants in particular have been criticized for being insufficiently forward-looking but, again, such comments are often wide of the mark.
Let's look briefly at two examples of “fresh” research. First, research from brain imaging clearly shows that, when it comes to handling risk, our brains are extremely irrational. We may think we have a built-in ability to handle risky situations, but behavioral and neurological studies suggest quite the opposite. For example, a powerful aversion to losses will often lead investors with mildly negative returns to take risky and ill-advised positions to make up those losses. Somehow we have to counter such irrationality — or take advantage of it when it presents money-making opportunities in the investment markets.
Second, why is our ability to deal with low-probability events so poor? A better understanding of extreme risk does not necessarily produce a perfect risk management model, but it might help to avoid disastrous outcomes. Extreme value theory, a statistically sound methodology to estimate probabilities of rare and damaging events, is only just beginning to percolate in financial markets.
Extreme value theory deals with events that do not fit well into a classical normal distribution and helps us to be prepared for outcomes that may be unlikely but which, if they occur, can be extremely painful. Both quant and non-quant managers can benefit from the concept of extreme value theory in portfolio management, but the typically more highly elaborated risk control techniques of quantitative managers will probably be able to incorporate this concept more readily.
The quant vs. non-quant debate will doubtless continue, but it really misses the point. Investors should focus on the manager attributes most likely to deliver the highest risk-adjusted return over the long term: a proven investment process, leading-edge technology, and ongoing original research on how to add value in complex and rapidly changing markets.
Ronald D. Frashure is president, chief executive officer and co-chief investment officer of Acadian Asset Management LLC, Boston.
