Can quantitative investment delivers positive investor outcomes?
The essence of a quantitative investment approach is straight-forward: it is the utilisation of rational economic and fundamental investment insights in a disciplined and consistent fashion.
In this article from GSFM’s investment partner Redpoint Investment Management, CEO Max Cappetta examines the merits of a quantitative investment approach and discusses the benefits of such an approach in separately managed accounts.
All investment managers use quantitative tools in various ways. Many use simple screens to help focus their detailed research on a smaller set of companies, which is especially important when managing global portfolios. The detailed research element often includes modelling a company’s financial statements and company visits to gain a deep stock specific perspective. The final step is then to incorporate the research insight into portfolios to meet both risk and return objectives.
Investment styles move in and out of favour
One problem with this traditional approach is that no one investment style or theme is consistently rewarded. A better approach is to research and use a range of disciplines to determine which stocks to own or not. 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. Applying this breadth of insight is where a systematic quantitative approach is different to managers who take a fundamental focus on one dominant theme or philosophy.
Another key difference is a fundamental manager will examine the absolute depths of specific companies and industries, whereas a quantitative manager will work across a broader range of individual stocks and industries.
Quantitative managers undertake fundamental research upfront to formulate various investment ideas. These ideas are then tested with complex mathematical and statistical modelling to ensure that they are supported across different markets and investment environments.
Both are legitimate and credible means through which to approach investing and can have varying degrees of success depending on the point in the cycle.
Quant working alongside other investment styles
A quantitative approach can effectively work in tandem with other investing approaches in the one portfolio. A diversified quantitative approach can act as a scalable core exposure assisting with both capacity constraints and cost in other styles or managers.
The fact that the quantitative portfolio utilises a range of investment insights can also lead to improved after-tax outcomes. As the value manager sells his winners (realising a taxable gain) some of them may have become attractive to the growth manager. Inside the diversified quantitative portfolio, the same position simply transfers from the ‘value’ allocation to the ‘growth’ allocation without the need to realise the position.
While ‘off the shelf’ systematic strategies are growing in number, investors need to be careful to avoid inadvertently investing into potentially crowded trades or poorly-structured exposures with large unintended risk exposures. Using last year’s earnings relative to today’s price can often be a poor proxy for company valuation. A quantitative approach will model the financial statements of listed companies to derive a forecast of future earnings. This will include specific handling of accounting anomalies, country and industry effects.
Risk control is also critical as stock selection insight can often be drowned out by unintended portfolio bets caused by naïve approaches to portfolio construction, signal rebalancing and trading.
Quantitative managers are also well-equipped to manage the increasingly important area of sustainable investing, including a direct incorporation of ESG metrics. For some active managers, having an investor ask to invest in certain stocks or to avoid certain stocks while remaining tied to the benchmark can be problematic, but is less of an issue for quantitative managers with a view on every stock in the investment universe. They can make effective risk and return trade-offs even when required to exclude specific companies from their investment universe.
Valuations and performance
As with all investment disciplines, the performance of systematic quantitative investment strategies is largely influenced by the market and economic environment.
The post-GFC investment landscape has been dominated by central banks doing all in their power to meet growth and inflation targets. This monetary stimulus has fuelled risk appetite to the point where both equity and bond market valuations are stretched.
Price volatility has fallen as investor confidence has responded to the implicit view that monetary stimulus will always be applied by policy makers to mitigate downside events. This skewing of markets has been a difficult environment for active managers to outperform in.
In our experience, increases in uncertainty and volatility across financial markets makes the investor focus more on the fundamentals of the company they’re buying. This is usually when traditional active and active quantitative-style management is in a better position to outperform and offer investors the best possible return.
Outlook and examples
Diversification in investment insights is key. An investor focus on one particular style may not pay off. A robust quantitative approach can aggregate multiple investment disciplines in the one portfolio.
Looking ahead, there are opportunities for a valuation discipline to be rewarded but it’s skewed towards avoiding stocks that are expensive. Within the current economic cycle, there’s not a lot of cheap valuation opportunities available.
Valuation in some financial services stocks, such as the local major banks, is attractive, but whether earnings will contract from here, or exactly how they can grow earnings in the future, is unclear. The risk is though they are relatively cheap, they may be cheap for good reason. Any sensible investment approach must seek to discern between the value opportunity and the value trap.
A recent case in point is the turmoil which has engulfed AMP Limited (ASX:AMP). Since the start of 2018, the share price has more than halved from over $5 to below $2. Making sense of the company’s financial position has required a detailed investigation of a range of events and data. Our quantitative assessment was that AMP was unattractive on valuation grounds when trading at $5. The company’s interim and financial reports through 2018 and 2019 raised a number of flags, determining that the stock remained a value trap rather than an opportunity as its share price fell. Our analysis flagged events such as increases in cashflow volatility, uncertainty across the financial statements and analyst estimates.
Taking a simplistic approach such as a focus on reported earnings or past dividends paid could have led investors to view the stock as attractive as the share price fell. However, a quantitative approach can include complex and detailed rules with the added benefit of being unemotive in decision-making.
Another sector with a question mark is local discretionary retailers, who appear to be trading below reasonable valuations. Again, the risk for such firms is that if there’s any dislocation, such as any impediment to consumer spending, then they may be at risk of underperformance.
Quantitative investment and the SMA wave
Investor adoption of SMA model portfolios continues to be a massive trend. Advisers and investors acknowledge that SMAs are an effective mechanism for melding the benefits of direct beneficial share ownership with professional investment management. The range of strategies available via SMA is growing quickly with strategies moving beyond domestic equities to global equities, fixed income and other direct assets. This broadening of the range of available strategies is likely to bring the SMA market to a new growth tipping point allowing investors to use an SMA structure for larger proportions of their portfolios.
While the SMA structure has many tax and transparency benefits, ultimately, SMAs are a vehicle for delivery of investment outcomes. Building effective strategies for implementation via a SMA structure is a key challenge now facing investment managers and platform providers: it also presents a major opportunity.
Building well-structured core strategies for SMA implementation:
There are many philosophies regarding how best to structure investment portfolios. A core and satellite approach using both passive and active strategies is among the most common.
Diversified passive strategies can provide broad exposure at low cost while complementary active satellites can further improve outcomes.
A key characteristic which all SMA strategies must adhere to is to be reasonably concentrated, rarely holding more than 50 securities. This is such that clients with small investment balances can still have the SMA Model Portfolio faithfully implemented. Most active strategies generally meet this constraint, however highly diversified passive strategies cannot.
One solution may be to continue to use ETFs and/or managed funds as core exposure vehicles; but this simply dilutes the tax and transparency benefits of the SMA structure. Some model providers offer simplistic strategies to provide, for example, the top 30 companies in a benchmark as a proxy for the passive index; but this approach is likely to come with unintended biases that could lead to poor outcomes.
Building core portfolios for SMA implementation requires the combination of three critical investment elements (figure one).
Building SMA strategies using a subset of companies from a benchmark requires that many assets are not held. This task automatically takes all strategies into the realm of active management. As we start de-selecting companies we immediately add active risk or tracking error. This required de-selection is an opportunity to incorporate investment themes and criteria such that the active risk that must be borne can also have some expectation for adding value in the long run and/or meeting a specific objective.
A systematic, or quantitative, approach is well suited to this task.
A range of objectives and themes can also be considered using a systematic approach. For example: lower volatility portfolios, income portfolios, a socially responsible portfolio or sector specific strategies.
Risk controlled portfolio construction
A prime feature of the SMA approach is that investors can directly access professional portfolio management services with advisers benefitting from greater business efficiency of not having to manage direct equity holdings. The SMA structure allows for portfolio management oversight to handle corporate actions, index changes and other events.
With increased investor sophistication comes the need to be able to provide a range of flexible solution to meet changing demands and cyclical themes. Portfolio design and construction capabilities need to ensure that the constraints of SMA implementation are properly incorporated.
Portfolio optimisation is required to ensure that unintended bets are mitigated while making better trade-offs between value add, costs and other necessary constraints. Left to its own devices, portfolio optimisation tools can induce excessive trading and or unnecessary small trades. A well structured quantitative approach is well positioned provide risk management while mitigating excessive rebalancing.
Manager oversight
Being able to embed investment insight as well as test and develop new ideas is a competitive advantage of a quantitative approach. While simplistic SMA approaches may be susceptible to cost pressures and substitution, smarter utilisation of investment knowledge can deliver better long term outcomes for investors.
The concentrated nature of SMA portfolios necessitates that model portfolios are active (relative to standard diversified benchmarks). The combination of investment insight, risk-managed portfolio construction and manager oversight afforded by many quantitative managers is a path to building better outcomes for investors.
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