CFA Says Quant, Fundamental Styles Are Tough Mix By Emma Trincal, Senior Financial Correspondent Tuesday, May 13, 2008 CHARLOTTESVILLE, Va. (HedgeWorld.com)—Since 2005 and especially since last year, quantitative fund performance has not been as good as it used to be. Now that many have come to realize that mathematical models are not flawless, a new trend in asset management is emerging: integrating the human touch of a fundamental approach into the blind computer-driven process. Called “fundamental overlay,” the approach to quantitative investing that incorporates human judgments in models appears to be, according to a recent industry survey, one of the newest trends in quantitative equity investing. But while the approach has appeal, not everyone is convinced it works. Although many fundamental managers are embracing stock screening systems, not all quant managers are convinced that they should model human behavior. Finding the right formula when mixing quant analysis and fundamental insight is challenging. And if unpredictable information, human judgment and emotions are new factors to be built into revised models, how does one quantify how much intuition and subjectivity should be factored into a model, assuming they can even be isolated as factors? This question is the subject of one of the chapters of a 110-page report commissioned by the Research Foundation of the CFA Institute. Released on Monday [May 12], the booklet is the result of conversations last year with asset managers, investment consultants, fund rating agencies and industry consultants, as well as survey responses from 31 asset managers across Europe and the United States with a total of $2,194 trillion in equities under management. Called “Challenges in Quantitative Equity Management”, the report is co-authored by Frank Fabozzi, professor of finance at the Yale School of Management and two founding partners of the Intertek Group in Paris—Sergio Focardi and Caroline Jonas. Mr. Focardi is an editorial board member of the Journal of Portfolio Management. Nine months after quants suffered significant losses in the summer of 2007 this report is a welcomed sum of research that tackles on three major points: How does one explain the summer shock that hit the quants so painfully last August? Does it pay off to add a fundamental perspective to quant-driven strategies? And what are the business challenges for firms that want to implement quantitative strategies for the first time? Quant Strategy At a Turning Point What prompted the CFA to commission this research was to find out what would be the future trends in quantitative active equity investing. In some ways, quant strategies have been the victim of their own success. Quants did very well during the 2000-2005 period, which led many managers to flow into this strategy. Citing some research estimates, the study’s authors said that during that five-year period, quantitative-based funds grew at twice the rate of all other funds. “But performance after 2005 deteriorated,” according to the report. It got worse last year, according to Lipper Inc., a company owned by Thomson Reuters, which itself owns HedgeWorld. According to Lipper data, quantitative funds underperformed non-quantitative managers last year, except in market-neutral strategies. The performance problem was at its worst for quantitative equity managers in the July-August turmoil, but it persisted in early 2008, leading many to observe that quantitative equity management was facing its first widespread crisis. The authors of the report asked survey participants to evaluate factors that led to the losses in the summer. Hedge funds are the first answer, and one that has been heard before. A number of highly leveraged funds had to de-leverage to meet margin calls related to the subprime mortgage crisis. It led to massive and distressed sales of stocks, the most liquid assets. But another explanation lies with the quantitative investment process itself. The rotation of styles—value versus growth—is part of the global problem of adapting models to changing market conditions, said the authors. The chief investment officer of equities at a large asset management firm was quoted in the report without being named saying, “Growth and value markets are cyclical, and it is hard to get the timing right.” Participants also attributed the declining performance to rising correlation levels as too many funds use the same factors for their models, or the same data for similar models. Overall, the perception was that for the first time, the models seemed to be deficient. One survey participant in the report sums it up: “The market turmoil of August 2007 was truly unique. The models all looked the same. Everyone was selling and buying the same thing. Quantitative equity managers found themselves with similar exposures to value and growth but, I believe, to a very different extent. Then, there is the question of awareness of conflicting signals. My perception is that hedge funds have become more multi-strategy, so in the August [2007] turmoil, they unloaded equity positions to meet margin calls.” Marrying Quant Models and Fundamental Factors The recent poor performance of quantitative funds led many to rethink the soundness of modeling. Some have asked whether the models, when operating on their own, did a sufficient job at predicting risks, sudden market swings and value/growth style rotations. When the answer was “perhaps not,” some quants tried to integrate certain elements of fundamental investing into to their processes. Inversely, some fundamental asset management firms got into the quant space driven by the success of new products. But was it a marriage made in heaven? Two-thirds of the survey participants disagreed with the notion that the most effective equity portfolio management process combines quantitative tools and a fundamental overlay. “Interestingly, most of the investment consultants and fund-rating firms we interviewed shared the appraisal that adding a fundamental overlay to a quantitative investment process does not add value,” wrote the authors. Yet, more than half of the participants in the study come from firms that use both fundamental and quantitative processes. The two types of businesses typically are run separately, but sources at these firms mentioned the advantage for quant managers of having access to fundamental analysts. In other words, it’s a mixed picture. Quant managers are reluctant to integrate a fundamental approach into their models. But it doesn’t mean that firms overall do not use both systems, albeit behind closed doors. Using a blend of quantitative and fundamental investing offers many benefits and quant managers are aware of such advantages. For instance, combining a judgmental and quantitative approach when everyone is using the same data or models can help a manager differentiate himself against competitors. Some quant managers surveyed admitted that while they may or may not be doing it yet, combining fundamental analysis and quant discipline could be a future trend. Choosing how much fundamental analysis to add in a quant-based investing strategy also may reflect choices made regarding risk. A consultant polled by the survey said, “The issue with the quant process is that a lot of investment managers struggle with estimating the risk-to-return ratio due to concentration. With a fundamental process, a manager can win a lot or lose a lot. With a pure quantitative process, one can’t win a lot: there is not enough idiosyncrasy. Hedge funds deal with the risk issue through diversification, using leverage to substitute for concentration. But this is not the best solution. It is here—with the risk issue, in deciding to increase bets—that the fundamental overlay is important.” Another source in the report, a quant manager, said using a systematic fundamental overlay “provides a common sense check.” He said that reading the 10-Qs and 10-Ks filings plus their footnotes provided “real-world” information that cannot be ignored. The problem with fundamental overlays is how to handle them. If the quant fund manager wants to introduce human judgments into the models in a scientific way, he faces the statistical challenge of measuring uncertainty. Human judgment is considered an event that cannot be predicted as easily as a probability occurring at a relative frequency. “Quantifying the probability of an event from intuition is a difficult task,” wrote the authors. That’s the reason why quant processes and fundamental analysis don’t necessarily marry well into one model. Most often, the two styles are run separately. The survey clearly showed that most quantitative managers are more comfortable with a pure quantitative approach that does not introduce judgments. Perhaps if there is a marriage of the two styles, it’s when fundamental managers jump on the quant bandwagon in backing their analysis with stock-screening systems. A third of the survey participants said that such a trend was increasingly important at their firms. The study attributes this new trend as the direct result of the success of 130/30 strategies, with a growing number of fundamental managers trying to get into this sector through quant techniques. The Challenges Of Implementing Quant Strategies Another chapter of the monograph examines the business issues pertaining to the motivations behind the adoption of a quantitative process as well as a list of the main barriers to entering this market. Tighter risk control was identified by the survey participants as the most important motive for adopting a quant equity investment process. Following closely, the two second most important reasons were getting more stable returns and better overall performance. Finally, the profile of a firm’s founder, along with the prevailing in-house culture, also was an important factor. Interestingly, bringing management costs down was rated by participants as the weakest factor behind the drive to implement a quantitative investment process. However, the study pointed to the fact that while cost was not a major consideration in firms’ decision to enter the quant sector, large firms with a quantitative process were more profitable than those run fundamentally. The authors of the survey also asked their sources to rate the barriers to new entrants to the quantitative equity investment space. The most important obstacle was the prevailing in-house culture, with fundamental-oriented managers opposing quant techniques and change. “The introduction of new technologies typically creates resistance because these technologies pose a threat to existing skills,” noted the authors. They added that such resistance is somewhat a paradox because “The introduction of computerized processes has often created more jobs (albeit jobs requiring a different skill set) than it destroyed.” The second obstacle was the difficulty in recruiting highly skilled staff, mostly Ph.D. professionals. “Recruiting the right skills,” one source said, “is a major obstacle.” The cost of qualified people was considered a less important barrier. ETrincal@HedgeWorld.com
“survey responses from 31 asset managers across Europe and the United States with a total of $2,194 trillion in equities under management” Seems like alot at first until you realize that it’s really only about $75 trillion per manager.
Would you be kind enough to post the link. Thank you.
Nevermind, found it.
Anyone notice all the Ethics Violations with using “CFA” as a noun 
Instead of saying the CFA Institute, they just say “The CFA to commission”…wonder what the CFA Institute will say about htis, haha.
newsmaker Wrote: ------------------------------------------------------- > “survey responses from 31 asset managers across > Europe and the United States with a total of > $2,194 trillion in equities under management” > > Seems like alot at first until you realize that > it’s really only about $75 trillion per manager. 75 trillion per manager eh? The global pool of capital is about that size (according to NPR)
I think 75 trillion is approximately Global GDP. Global capital is probably 10x to 20x more than that, assuming a perpetual discount rate of 5% to 10% and zero growth (bad assumption, but I’m just trying to get orders of magnitude here). But I agree. I don’t think the average manager is trying to handle $75 trillion.