By Ryan Caldwell
More money than ever is flowing into factor-driven strategies and investors are increasingly trusting passive products to deliver performance, and control the one variable in investing known in advance—costs. While technology entered investments years ago, today’s incorporation of advanced algorithms, artificial intelligence and deep learning is still in its early stages. There are strong views on both sides of: the systematic versus discretionary, active versus passive, and man versus investing machines debates. Volatility in factors demonstrates why using machines is valuable to interpret security price movements and explains the drivers of underlying investment performance, however, combining fundamental analysis and judgment is important to achieve better outcomes.
As asset managers grapple with fee and profit margin pressure, the industry will likely see a convergence between fundamental and quantitative processes to generate investment value with fewer bodies and more machines. This could be a cultural challenge for most actively managed firms given the visceral response that practitioners have for one another’s work. Quantamental, combining fundamental and quantitative approaches, offers a hybrid, efficient investment process for the new world of investment management.
Hand in Glove
Melding quantitative tools with fundamental research makes investing smarter, but an investment team and the culture needs to keep quantitative inputs and fundamental processes fully integrated. First, the quantitative process reveals what game the market is playing to help understand what style shifts (i.e., growth versus value) are underway and how the market is pricing certain baskets of stocks across the globe. Next, fundamental research should dig into selecting the right securities and calling the factor plays and weightings. Together, this two-stage investment process offers improved insights from changes in management and investor behavior. An ideal investment process using today’s advances emphasizes active management, quantifies fundamental factors and applies a systematic approach to judging data sets used to inform asset allocation and security selection decisions. Quantitative discipline should keep fundamental analysis focused on “what matters when” by systematically shrinking the opportunity set to specific areas of the globe and to factors that present the best potential outcomes.
Fundamental Is Only Human
Humans are emotional. Combine emotion with investing and you can get irrational capital allocation decisions that result in unpredictable outcomes. Traditional fundamental analysis relies on human judgment and can fall victim to “narrative fallacy.” Behavioral biases can oversimplify complexity into soundbites that may be great for storytelling, but poorly translates into business economics and long-term value creation. Fundamental analysts can travel far to data-mine “facts” that enable their “thesis,” ignoring the fast-shifting global investing context or broader market conditions underpinning portfolio allocation or security selection decisions. That said, experience conducting fundamental research can add meaningful value through understanding key trends, sector expertise and by asking the right nuanced questions to gauge management and investor behavioral changes. Fundamental analysis comes with forecasting errors so investors should recognize the risks of overconfidence and extrapolating trends so far ahead. Just take the human forecasting error during last year’s U.S. presidential election for example. Human foibles interfere with many active managers’ abilities to consistently outperform. Much has been said about the underperformance of active versus passive strategies and therefore investors continue to expect that active can’t outperform passive management and tilt their portfolios too far, irrationally eliminating all humans.
Machines Cannot Cure All
The adoption of factor-based, smart-beta and rules-based active investing products has reached a fever pitch, yet it’s not technically a new technique for fundamental stock pickers. There are many factors, ranging from style, sector, country or a market cap cohort, that both fundamental and quantitative investors use to measure portfolio risk. Quant-investing alone is not perfect and can be relatively opaque or, even worse, give no justification for recommendations. Some quant practices can also add unnecessary complexity to data analysis by using too many programmers, ultimately removing portfolios from proven reliable economics, finance and valuation precepts. Investors need not forget that investing by grouping stocks on common backward-looking attributes that have historically moved together doesn’t tell enough about what they’ll do in the future. Quant work cannot anticipate management or policy-making behavioral changes because it doesn’t replace judgment. In 2016, this had profound implications across global financial markets and greatly impacted optimal portfolio construction as factors like “stability” proved to be more correlated across sectors and asset classes than many crowded investment strategies anticipated. The responses to outcomes and what will affect future quant-model rankings truly matters and once the dots get connected, portfolio risks can quickly be re-rated.
Asset Allocation and the pieces of Quantamental Investing
It was once said, “In order to figure out where we’re going, we have to figure out where we are.” Investors should utilize a quantamental investing process that delves into quantitative models and conducts fundamental research to help understand the impact of our current environment. This blended approach will help seek out the prevailing market condition and clarify how to adapt your investment objectives to either capital preservation or capital appreciation. It allows investors to constantly monitor and react to an ever-recurring growth/value cycle. The quantamental approach enables algorithms to keep up with the ever-evolving industry, models to make sense of the investment universe and minds to make the allocation decisions needed.
Ryan Caldwell is co-founder and chief investment officer of Chiron Investment Management, a boutique, multi-asset investment management firm.