Why Quant Now?
11 October 2016 / Anthony Lawler, Adam Glinsman
Is your diversified portfolio a single factor bet?
Investors in equities and bonds have been
nicely rewarded since the Global Financial
Crisis (GFC) as both asset classes have
rallied substantially since. It has been a
great dual beta trade. But fundamental
investors searching for value opportunities
have, by and large, struggled to outperform
since 2010. Why is that so, and are these
two points related?
Part of the answer is that fundamentals
– the valuation metrics, such as the price-to-earnings (PE) ratio, which investors
use to assess the relative attractiveness
of a security’s price – have taken a back
seat to central bank policy in driving price
determination. All liquid assets, including
equities and bonds, have rallied with the rising
tide of liquidity provided by the world’s central
banks. There has not been much reward for
seeking out fundamental value. Either you
were in the boat (i.e. long equities and bonds)
as the tide rose or you were not. But where
does the journey go from here?
High valuations and a hidden factor bet
The tide (i.e. valuations) seems pretty high.
Real bond yields are hovering around zero
and equities look expensive on measures
such as earnings growth and the Shiller
Cyclically Adjusted PE (CAPE) ratio. If both
bonds and equities are expensive, the
question of effective diversification becomes
critical. As such, we see that investments
using long-only fundamental style tilts including value, growth or quality, are
attracting more interest. But we think that this
could be an unintended single factor bet: the
bet that fundamentals will drive asset price
moves in the near term. This factor (company
and security-level fundamentals) could
continue to underperform if prices remain
disconnected from fundamental drivers.
Instead, market technicals and macro issues
– namely the size of central bank balance
sheets and the methods of quantitative
easing – could continue to be the main factor
in determining prices.
So, how can investors diversify if the
market seems expensive and to not be
One effective way to diversify is to invest
in strategies that do not generate returns
based solely on fundamental analysis. These
strategies, which take positions based on
price movements and other non-fundamental
data, are often rules-based systematic
Systematic trading models utilise computer algorithms
that assess data and make investment decisions based on
information that is broader than pure fundamental valuations.
These quantitative systematic strategies typically include
the consideration of price factors (for example, trend, mean
reversion, pattern recognition or statistical arbitrage). The
bottom line is that if you can invest in quantitative strategies that
are not simply long the assets you already own, and are not
solely evaluating asset fundamentals, then you might find some
diversification away from beta and the potentially unintended
bet that fundamentals will drive prices in the short run. And that
could be very valuable diversification for one’s portfolio.
This hypothesis is supported by historical performance and
correlation statistics. The long-term return profile of highly
liquid quantitative strategies has proved compelling as a
return generator and portfolio diversifier. Using simple rules-based trend-following strategies as an example, over the past
decade to August 2016, the quantitative trend-following SG
Trend index has produced a 5.1% annualised return with a
very low correlation to the S&P 500 of -0.02.
So, are systematic strategies a panacea in today’s investment
environment? Of course not. But investing in strategies that
(a) do not depend on staying long expensively priced beta,
and (b) do not depend on fundamentals being rewarded by
the market in the short term, offer valuable diversification.
The systematic investment universe has grown from an asset
base of USD 408 billion in 2009 to some USD 880 billion
today, according to Financial Times data. Investors are
realising the difference that sophisticated technology can
make when it comes to portfolio robustness. Interest in these
strategies is creating something of a technological revolution
in investment management, combining lessons learned from
prior cycles with the precision, speed and cool-headed risk
management of machine-based approaches.
As with any investment style, there are risks, including crowding
and market reversals. But systematic strategies form part of a
diversified portfolio solution. These strategies can help address
the lurking risk of limited diversification in traditional portfolios
today. Two of the biggest threats facing investors today are
- 1. that long-only traditional assets (equities and bonds) are
expensive compared to history and are less likely to deliver the required returns from here, and
- 2. the unintended factor bet that the whole portfolio is
positioned based on fundamentals, which could continue
to be ignored by markets dominated by central banks’
decisions. Investors should therefore examine their
portfolios closely to identify potential large factor bets and
take steps to counterbalance those. Adding quantitative
strategies should diversify those risks.