The Quants Run Wall Street Now

By Monday May 29th, 2017 Investment

In a very recent May 2017 Wall Street Journal article the authors argue exactly that.Does that mean that the active, qualitative, stock picking approach to investing has been overtaken by the passive, smart beta driven, quantitative approach?  Well yes. There are a number of reasons for this as well as a number of challenges.

Portfolio returns are the result of both asset allocation (quantitative) and active stock selection (qualitative) decisions. The importance of asset allocation has been verified by a number of academic studies which confirmed that decisions on allocating to different underlying investment markets or asset classes account for significant performance difference between portfolios. In fact academic studies and empirical evidence have shown that the majority of returns can be explained by an investment program’s asset allocation. This insight would tempt investment managers to concentrate on asset allocation and rely more on investing in a passive portfolios or indices.There are a number of challenges in doing this which are dealt with below.Let’s ignore the smart beta constructed funds and concentrate more on the traditional cap weighted index funds. Since 1995 assets in passive equity funds and exchange traded funds (ETFs) have grown significantly. From 4% of US equityfunds in 1995, they had jumped to 27% by 2011. Investing using passive indices can certainly have benefits, including diversification, transparency and low costs, but passive strategies also carry their own risks. These include undesirable concentrations of stocks, systemic risk and buying at too high valuations.For instance, traditional equity indices weight the stocks that they contain by market capitalisation, so that bigger companies dominate. In effect investors are buying into yesterday’s winners. These are the biggest stocks which performed well historically, but are now more prone to underperform as smaller stocks erode their market dominance. This effect is evident when a traditional market cap weighted index, such as the MSCI World, is compared with an index that removes the market cap bias, such as the MSCI World Equally Weighted Index. The market cap weighted index lags significantly in performance compared to the equal weighted index.

Another problem that passive investors need to overcome is the lack of breadth that comes from an investment strategy based on indices. An index-bound investor unnecessarily restricts their investment choices. For instance, while the MSCI World Index is currently composed of over 1,600 stocks, we calculate that the universe of global stocks with sufficient investable liquidity comes to more than 15,000.

Equally challenging is the fact that large concentrations develop in traditional market cap indices. For instance, in February 1989, 44% of the MSCI World was composed of Japanese stocks as a bubble formed in Japanese asset prices. Again, in February 2000, technology and telecoms stocks made up over 35% of that same global index. In both cases, these two parts of the market – Japanese stocks and the technology and telecoms sector – underperformed badly as their high valuations unwound in subsequent periods. This concentration risk has not gone away. At the end of February 2014, just over 9% of the value of the MSCI World Index – tracked by many passive funds – was represented by the top 10 stocks, or less than 1% of the total by number.

One recent study by Antti Petajisto, whilst a finance professor at the NYU Stern School of Business, has found that, on average, US active equity managers do have the ability to outperform the index. However this outperformance is often eroded by fees and transaction costs. Interestingly, though, one type of manager was found to be more likely to outperform net of these costs: ‘stock pickers’ whose portfolios diverged markedly from the index. This group took positions that were significantly different to the benchmark, yet their risk relative to the benchmark was lower than the concentrated managers group. Does that mean that the reign of the Quants is threatened? Time will tell.

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