Quantitative investing

will quants strike back? Quantitative equity managers (quants) have experienced a roller-coaster ride in the past 10 years. Throughout the middle of the last decade, life was good for quants: performance was strong, asset inows were signicant, and even fundamental managers were embracing the merits of quantitative tools in screening and portfolio construction. Today, however, investors often exclude quants from their agenda.
What went wrong? How has the industry reacted? What is Towers Watsons current view on this group of asset managers? In this thought piece, we answer these questions and suggest what opportunities may lie ahead for quantitative approaches. The early 2000s changed the scene. Having gone through the dot-com bubble unscathed, quant strategies gained widespread legitimacy, becoming popular with investors and attracting dramatic growth in assets on the back of strong returns.3 Strategies employing leverage were particularly successful. Many fundamental managers adapted their processes to make greater use of quantitative insights. The end for traditional fundamental approaches seemed nigh. But the history of financial markets is replete with humbled investors and the extraordinary success enjoyed by quantitative strategies proved to be short-lived. Many quantitative managers have performed poorly (see Figure 01) and just as strong performance led to strong inflows, the opposite has also come to pass. Quantitative investing is, for many today, out of fashion.

Quants on a roller-coaster
Quants, who use systematic factor-based models to analyse and invest using widely available data, have a long history in equity management. Financial market historians ascribe the beginning of quantitative investment strategies to Harry Markowitzs seminal work on portfolio theory in 1952. 1 From a few early adopters, quants slowly found their place as providers of niche investment approaches alongside traditional fundamental managers. Much of that popularity stems from the growing support of finance academics.2

Figure 01. Relative rolling ve-year performance of a representative group of large active quants 4
Return (US$, pa) 6% 4% 2% 0% -2% -4% -6% 2007 2008 2009 2010 2011 2012

Source: eVestment, Towers Watson

What happened?
Too many assets
In our January 2008 article, Quant management at an inflection point, we painted a cautious view on quants. Our concern was primarily driven by the significant increase in assets, often leveraged, managed using quantitative strategies. We felt that structurally low barriers to entry and prolonged favourable market conditions had encouraged excessive asset gathering (see Figure 02) in broadly similar strategies, thereby reducing the attractiveness of the opportunity set. Extreme market events, such as the quant crunch during the summer of 2007, were caused by crowding in other words, too many assets chasing the same return factors. Quantitative approaches, relying largely on historical information to forecast risk and return, were not well-suited to capture the systemic risks created by these crowded trades. For example, before the financial crisis, few quantitative managers used valuation spreads to assess the attractiveness of value. Even fewer had developed indicators to monitor crowdedness.

Figure 02. Increase in quantitatively-managed assets 5

Assets (US$ billion) 70 60 50 40 30 20 10 0 2004 2005 2006 2007

Source: GMO

The trend is not always a quants friend

The risk-on, risk-off macro-led market environment seen over the past few years has been challenging for active equity strategies, whether quantitative or fundamental. Two investment styles in particular faced headwinds in this environment: value and momentum. We discussed our views on value in a recent article.6 Momentum is a trend-based investment style that struggles at major market inflection points (as, by definition, it lags behind changes in market leadership). Many quants use momentum to add diversification to their often value-biased approaches. As the two styles are expected to be complementary, the theory is that a combined approach should generate smoother returns. This had been the case for many years. However, when both styles underperform there are few places for a quant to hide, particularly if the strategy is expected to add value over the short to medium term. As Figure 03 suggests, it is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers.

Figure 03. Relative rolling ve-year performance of value and momentum 7

Return (US$, pa) 20% 15% 10% 5% 0% -5% -10% 1998 2000 2002 2004 2006 2008 2010 2012

Momentum Value
Source: Style Research Ltd, Towers Watson

...it is no coincidence that recent style headwinds in value and momentum coincided with negative performance for quantitative managers.
2 Quantitative investing will quants strike back? towerswatson.com

All change please

Over the past five years, quants have had to face a challenging environment. Many quantitative managers decided they had to change their approaches significantly, in order to maintain a competitive edge. By and large, these efforts have focused on three areas: uniqueness of insights, style-timing and more judgemental input. Unique insights To avoid the issues resulting from the crowding of factors, quantitative managers have worked hard to identify unique insights. Some managers sought newer, differentiated data sources or worked to build proprietary signals, leveraging less exploited relationships between data and expected returns. Style timing Style-timing has been at the top of the research agenda. Quantitative managers have increasingly attempted to make use of dynamic risk/return frameworks that adapt to changes in equity market leadership. Judgemental input Some managers have decided to broaden their risk/return framework by adding macro-based signals or to rely more on fundamental or thematic judgement to compensate for the limitations of their quantitative models.

that some style-timing indicators may have long-term signalling power. However, many managers are required to deliver alpha over the shorter term, and style inflection points are very difficult to predict with accuracy. Back-tests of style rotation indicators are, by definition, period-specific and we have observed a number of these processes struggle when used in real-life scenarios.

Factor differentiation
We are cautious of managers claiming an edge through the exploitation of unique factors. Such factors are, in fact, rarely unique. We see similar insights spreading rapidly across the quantitative investment community, inevitably impairing their effectiveness. In order to prolong its competitive advantage, a manager may become more secretive. But this reduces transparency and can make it more difficult to confirm competitive advantage. Data mining can also be an issue as ever-growing swathes of data series are scrutinised. Finally, even when we see more differentiated factors, they frequently do not account for a significant part of the quantitative models overall risk budget.

Low assets
Everything else being equal, a modest level of assets under management is an advantage. Our view remains that it is easier to deliver alpha with total assets of US$1 billion than it is with, say, US$20 billion. This is particularly true for higher portfolio turnover approaches which use factors with a short time horizon for potential added value.

What we look for in quants

Not all innovation has resulted in improvements. Whilst still relying on traditional factors, quantitative equity strategies have become increasingly heterogeneous and complicated. This has raised the bar for asset owners and consultants when seeking to understand and assess these strategies. However, we believe there are a few quantitative managers that are ahead of their competitors and can demonstrate credible differentiation in their approach. Some of the key things we look for are:

Suitable fees
Fees for quants are often too high for the likely level of value added. Managers often have over-optimistic assumptions about the future information ratio (the ratio of relative return per unit of relative risk taken) of their strategies. Some managers also develop products with very low active risk in order to optimise gross information ratios of the strategy, effectively ignoring the real-world drag from fees paid by clients.

Introspection
The best quant managers are highly reflective and well aware of the natural shortcomings in quantitative approaches. They know that quantitative tools may introduce discipline but are not inherently better than traditional, subjective methods. These managers are more likely to foresee problems rather than react to events.

Pragmatic market awareness

It is important that managers complement robust historical studies with a pragmatic and intuitive understanding of markets. For example, we think

...quantitative equity strategies have become increasingly heterogeneous and complicated.

towerswatson.com

Quantitative investing will quants strike back? 3

The rise of smart beta

We do not subscribe to the belief that traditional quantitative factors have been permanently arbitraged away. We expect the well-documented behavioural phenomena behind these factors, such as the premium associated with basic valuation ratios, to recur over the long term and provide opportunities for patient investors. Market innovation is making quantitative investing more commoditised. This may present challenges for some types of active manager. However, for the asset owners, this trend is good news. Systematic equity exposures can increasingly be accessed through cost-effective, transparent and easily-implementable investment strategies, leading to improvements in overall investment efficiency. We have long been advocates of such solutions which we call smart beta that bridge the gap between passive and traditional active approaches. Index providers and passive managers have so far been at the forefront of the smart beta trend. There is now a widening range of indices and products that offer alternatives to the default market-cap weighted index. Of course, some of the caveats that apply to quants also apply to systematic smart beta approaches. Indeed we believe that traditional quantitative managers have a role to play within smart beta, given their extensive experience of the practicalities of quantitative investing.

Conclusion
Following disappointing performance from some products, traditional active quantitative equity investing is now far less popular. We have a positive view of some strategies, but remain cautious on this group as a whole. Despite efforts by managers to differentiate themselves, innovation rarely remains unique for long and process enhancements often lead to greater complexity. Nonetheless, we believe that quantitative investing can still play a useful, and expanded, role in portfolios via greater use of smart beta strategies. Asset owners can use systematic strategies to target style exposures inexpensively and in a way that is consistent with their beliefs or portfolio construction needs. To achieve this, it may not be necessary for quantitative approaches to use unique inputs or to be very complicated if they are well-grounded and available at reasonable fees. A smarter quant could be a simpler quant.

Further information
For further information please contact your usual Towers Watson consultant, or

Fabio Cecutto
+44 20 7227 2378 fabio.cecutto@towerswatson.com

Notes:
1 H  arry Markowitz. Portfolio selection. The Journal of Finance, March 1952. 2 F  or example: Fama, French. The cross-section of expected stock returns. The Journal of Finance, June 1992 or Jegadeesh, Titman. Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of Finance, March 1993. 3 F  or example, Casey, Quirk & Associates. The geeks shall inherit the Earth?, 2005. 4 A  verage relative returns of representative active global or international equity strategies from 10 large quantitative managers. Manager selection based on assets managed in active quantitative-only strategies. Performance is relative to stated strategy benchmark, gross of fees. 5 U  S$ value of coincident holdings, as taken from 13F filings in US, of the largest eight quantitative-only investment managers.
Disclaimer This document was prepared for general information purposes only and should not be considered a substitute for specific professional advice. In particular, its contents are not intended by Towers Watson to be construed as the provision of investment, legal, accounting, tax or other professional advice or recommendations of any kind, or to form the basis of any decision to do or to refrain from doing anything. As such, this document should not be relied upon for investment or other financial decisions and no such decisions should be taken on the basis of its contents without seeking specific advice. This document is based on information available to Towers Watson at the date of issue, and takes no account of subsequent developments after that date. In addition, past performance is not indicative of future results. In producing this document Towers Watson has relied upon the accuracy and completeness of certain data and information obtained from third parties. This document may not be reproduced or distributed to any other party, whether in whole or in part, without Towers Watsons prior written permission, except as may be required by law. In the absence of its express written permission to the contrary, Towers Watson and its affiliates and their respective directors, officers and employees accept no responsibility and will not be liable for any consequences howsoever arising from any use of or reliance on the contents of this document including any opinions expressed herein. Copyright 2013 Towers Watson. All rights reserved. TW-EU-2013-30601. March 2013.

6 Value investing an old idea, but probably a good one, Towers Watson, January 2013. 7 S  imulated performance of selected strategies; momentum: highest quintile by 12 months price momentum; value: highest quintile by earnings yield. Universe: Largest 2500 global companies in global universe, market-cap weighted, quarterly rebalance.

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