The law of 'quant' amid a global pandemic
Quantitative investors research and use a range of disciplines to determine which stocks are worth acquiring and, importantly, those which are not worth buying.
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. This differs from a traditional fundamental approach which usually focuses on just one style or investment discipline.
Both traditional and quantitative approaches are founded on a belief that investment strategies can be built to outperform passive approaches; a quantitative approach relies on breadth. By accepting that no one investment discipline is consistently rewarded, a quantitative approach will seek a broad range of inputs. This results in a highly-diversified portfolio with many small bets (overweight and underweight) relative to its benchmark. A traditional approach will rely on depth of conviction by focusing in specific sectors or style groups and relying on individual analysts to research a small sub-set of investment opportunities in detail. The outcome is usually a more highly concentrated portfolio consisting of a smaller number of larger relative bets.
Both approaches require an information edge to succeed, and is derived from research and analysis. Both quantitative and fundamental approaches utilise financial statement analysis. Both will consider a range of other data: broker forecasts, news events, economic and risk analysis. A quantitative approach will take advantage of its capacity to analyse vast amounts of data quickly and systematically, whereas a fundamental approach will focus on a much smaller research universe, seeking to identify a smaller number of opportunities with high conviction.
A quantitative investment manager will rely on being able to combine perspectives on a firms’ valuation, growth prospects, earnings certainty, market sentiment and risk. These are then used in a risk-managed way to construct a portfolio.
Each of the insights will have been tested to determine their performance through different markets cycles and economic circumstances. Back testing of strategies helps to ensure that specific stock selection insights are reflected in the portfolio appropriately proportioned to their expected future return and risk. Judgement and experience are also key: history never repeats but it often rhymes.
UNCERTAIN TIMES
An active quantitative approach remains highly relevant in today’s investment environment. The COVID-19 crisis is a health and economic crisis unlike anything the world has seen since – rivalling the second world war for economic fallout and consequence. The ongoing effects of the pandemic will continue to impact society and the economy long after the immediate health crisis has been dealt with.
There is no doubt that the current situation is economically painful and highly uncertain, however share prices will be more volatile than the underlying fundamentals of good businesses over the long term. For investors, it is important to remain focused on the longer term – through to the other side of the pandemic. As we saw in the Global Financial Crisis (GFC) in 2008/2009, prices initially fell and dividends were cut. The share prices rallied back in 2009 ahead of dividends being fully reinstated.
GENERATING RETURNS
As with all investment philosophies, the performance of quantitative strategies is largely influenced by the market and economic environment.
Post the GFC, the investment landscape was dominated by central banks injecting liquidity into the system, with this monetary stimulus fuelling the risk appetite of investors.
During this period, price volatility fell (low dispersion) as investor confidence responded to the assumption that monetary stimulus will always be applied by policy makers to mitigate downside events. Traditional markers of valuation became less relevant as interest rates fell to (and remain) near zero. The present value of future cashflows discounted at low rates has allowed for higher valuations to be ‘normal’. Investors starved for returns in the cash and bond markets have been attracted to any and all growth opportunities in the equity market, sometimes at ‘any price’. This has been an especially challenging environment for managers focused on valuation. This skewing of markets meant it was a difficult environment for active managers to outperform.
Fast forward a decade to the COVID-19 crisis, and investors are likely to have to contend with lingering volatility. This increased uncertainty across financial markets is expected to drive investors to focus on the fundamentals of individual stocks, and is usually when traditional active and active quantitative-style management are able to outperform and offer investors improved return. Among this uncertainty, investors will be reacting to fears of further market falls on some days and fear of missing out on others. A quantitative approach, by virtue of being systematically disciplined, can remain devoid of emotion and make decisions based purely on the numbers.
The quantitative approach analyses the same financial statements data used by fundamental analysts. Specific metrics are calculated from reported data and stocks are scored on various characteristics aligned with the company exhibiting financial strength (or weakness), cheap or expensive valuation, or that are being re-rated by investors. This analysis is both retrospective and forward-looking.
Historical outcomes can be used as a base forecast for the future. Forward estimates from broker research teams can also be gathered to enhance forecast metrics. One research team will monitor and evolve the decisions rules over time, with these insights then combined and used to construct a portfolio. Risk-controlled portfolio construction – which uses a range of disciplines to determine which stocks to buy – minimises the unintended biases inherent in more simplistic screening approaches.
THE ROLE OF ESG
There is no doubt there is increasing demand for investment strategies which embed sustainability considerations within their delivery, and this demand shows no sign of abating. A quantitative investing style can effectively accommodate an investors desire to acquire companies which adhere to environment, social, and governance ESG principles.
Having a perspective on how firms manage their risks in terms of their ESG practices, for example, can assist in identifying good quality firms which are being well managed for the long-term. Combining this with rigorous analysis of the company’s financial statements can provide new insights towards making better investments for the long-term.
This is where quantitative investing comes into its own. It uses both financial and non-financial investment insights in a disciplined and consistent fashion. It makes intuitive sense that the way in which a company manages its environmental footprint, for example through energy and water utilisation, will affect earnings over the long term. A quantitative approach will seek to understand this relationship through statistical research across all industries and countries.
Over the past 10 years, there have been a lot more companies that have started reporting ESG data, and a lot more data vendors who have started expanding their ESG data coverage. Similar to their influence on broader society, technology and data have had an ever-growing impact on the world of ESG investing. Relying on sound data collection processes of underlying ESG vendors is an efficient means of collecting and managing data available. Although sourced externally, the critical step in rating an investment on ESG factors is how a manager uses the data.
Some quantitative managers will internally develop a process which evaluates what components of the data are material, and what makes sense in terms of that respective manager’s specific investment process. An example of this is the vision of a company – this is an important marker in some ESG data sets, but it is not one that is well-suited for a quantitative investment process. However, while certain aspects of ESG data related to health and safety are easily quantified and are a window into staff productivity and wellbeing, it is important to understand the strengths and limitations of data available in this space.
Considerable time and effort are ordinarily required to develop frameworks to standardise data – it is an inherent by-product of quantitative investing. A critical part of this standardisation is establishing a stable universe of securities and then rank each security for ESG consistently relative to this universe.
Because of the proliferation of ESG data reporting in the market in recent times, there is a great deal of data available to perform this ranking task.
In addition to standardisation over a stable cohort of companies, a quantitative manager might look at the data being utilised to ensure a reasonable balance between indicators which are comparable across countries and industries, and indicators which drill down into specific company level information.
Incorporating all these elements are important when thinking about standardising data within a quantitative investment process. This highlights the art and science of a quantitative approach. Using data blindly can lead to incorrect or inaccurate conclusions. Being totally led by the data can paint a rosy picture of the past which will bear no resemblance to what may be achieved in the future. A quant approach needs to be guided with experience and knowledge of the characteristics of investment outcomes.
Greater availability and access to ESG data is more material than the standardisation of it. While a quantitative manager would be comfortable selecting and standardising data in keeping with its investment process, gaining access to deeper, more accurate and more timely data is what would be more useful to investors over the longer term.
A quantitative approach is also adept at tailoring investment outcomes for specific client needs. Some clients may wish to incorporate ethical investment criteria or some may wish to have portfolios with higher or lower active risk relevant to a benchmark. The quantitative portfolio construction process is well placed to deal with multiple investment objectives. Many traditional active managers offer one specific strategy or a small number of variants. Neither approach is better or worse but simply highlights some of the different ways in which a quantitative and fundamental approach are best utilised.
The data space is rich and complex – and different individuals will have different perspectives even if they are of a like mindset or come from the same organisation. The challenge is to provide a data framework that allows investors to tailor portfolios to meet their ethical belief set, while also managing the risk implications associated with their decisions and managing for the long-term capital appreciation that they need from their investment.
Max Cappetta is CEO and senior portfolio manager at Redpoint Investment Management.
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