Monday, March 3, 2014

10 Things That Worry Quants

From ZeroHedge:
Fundamentally oriented investors tend to think that quants, like blondes, have all the fun. As ConvergEx's Nick Colas notes - it all looks like easy money - scalping trades with lightning fast computers, front running news with preferential access to press releases, or managing leveraged portfolios with thousands of small but profitable positions – but quants face their own significant challenges. Finding common rule sets that work in a wide array of stocks is not easy, and markets adapt quickly to close opportunities that seem historically profitable - the number of potential signals is seemingly endless; and regulators are now aware of quantitative investing and, in some cases, don't like what they see. Here are 10 reasons why why "it's not easy being a quant."

In summary, Colas points out, the fundamental/quant investor divide is a case of “The grass is always greener on the other side of the fence.”
Via ConvergEx's Nick Colas,

Have you ever had one of those dreams where you are out in public and suddenly realize you’ve forgotten to put on your pants?  Everyone is staring at you, and for a while you just wonder why.  Do you look especially attractive today?  No, that can’t be it; some people are laughing at you.  Then you realize: no pants!  General embarrassment ensues.  And then, hopefully, you wake up.

I had an analog experience today while presenting at a conference entitled “Quantitative Investing with News & Sentiment Analysis” hosted by Deltix and RavenPack, two preeminent vendors in the front-page world of quant investing.  The organizers asked me to give the lead-off talk to the room of about 100 number-crunchers, the topic of which was basically “What does the rest of the investment world think about quants?”   My message was as follows:
Capital markets connect investors, managements, employees, retirees and other savers – basically everyone in society – together into one economic ecosystem.  As such, markets are hugely important and their credibility is a lynchpin social issue.

Fundamental investors – I used famed Fidelity Magellan Fund manager Peter Lynch as one example – are useful spokespeople for capital markets.  They connect what goes on in asset prices, especially equities, to economic outcomes in a way people can understand.  And, if they do as well as Peter Lynch did for his investors, these “Heroes” of capital markets can act to give the broad population some confidence that market-based capitalism really is a sensible way to organize the allocation of scarce resources.

The issue quant investors face is that their newer approach to capital allocation, based on technology and math and speed, hasn’t yet developed the utility of their narrative back to society as whole.  Indeed, its opaque and fragmented nature can engender suspicion from existing capital markets participants and regulators.
The whole “Hero” narrative, I thought, was a neat way to explain both why fundamentally minded investors have trouble with quant investors and to recommend some solutions to bring this Hatfield – McCoy style divide a bit closer together.  Perhaps it was the fact that I was the first speaker, or perhaps the coffee didn’t kick in, but at the close of my brief chat it took a little while to get some questions from the audience.  Always an embarrassing moment, that part where you say ‘Any questions?’ in a chirpy voice but only hear crickets in return.  I checked to see if the whole pants thing was the problem, but no…  They even matched the jacket.

Later, as I listened to several presentations by other speakers and the very lively discussions about their back tests, mathematical equations and statistical regressions, it struck me just how truly different the quantitative approach to investing is from the fundamental school.  As a long time adherent of the latter, I have always been a bit jealous of the former.  As it turns out, the grass isn’t necessarily greener on the quant side of the fence.  Come to think of it, It might not even be grass over there…
Later in the day, I jotted a quick Top 10 list of ‘Why it is actually tough to be a quant after all”:

1. They are just as lost as any fundamental investor.  As I listened to the morning’s presentations, I expected to hear about wildly successful algorithms and quantitative processes that had excellent back tested results and were delivering outsized returns with minimal risk.  The gating element I expected to hear about was computing power, or execution speed, or access to large and complex datasets.

The reality is that quant investing is still in a relative infancy, with debates like “How much does news really move a stock?”  Fundamental investors simply try to forecast specific events like better than expected earnings or revenue shortfalls.  Quants need to know that, plus how much, on average, will such news change the stock price?  Not easy stuff, and the targets change frequently.

2. Developing common rule sets for different stocks in various sectors/markets is difficult.  Imagine coming up with a common set of trading guidelines that could apply to all the stocks you know well.  Some are easy – a big earnings beat, or a surprise dividend boost.  But how about news in the supply chain?  Or the customer base?  The former, as it turns out, has less impact than the latter.  But figuring that out takes time.  A lot of time.

3. The relationships between stocks, fundamentals, and news changes constantly.  Remember the move off the 2009 lows for U.S. stocks, as low-quality companies had much larger returns than their high-quality peers?    Makes all the sense in the world to a fundamental investors, since the highly leveraged third-tier player in a tough industry with a $3 stock will bounce to $10 long before the #1 company in a great industry will even double.  To a quant that killed it from 2006-2009, however, that’s nightmare material.  Worse than the pants dream.  Their model was likely tuned to own quality companies and short the bad ones.  How do know when to flip the whole process on its head?  And would your investors forgive you if you got it wrong?

4. Math both helps and gets in the way.  Make no mistake – quants know numbers.  And models.  And they have access to a myriad of financial information.  But they also only have 24 hours in a day – the same as the rest of us.   They can be caught in analysis paralysis the same as a fundamental investor can feel the need to visit every single operation of a complex company before they make a recommendation.

5. The good stuff is very difficult to use.  Twitter is a big topic in quant land at the moment.  Everyone in the room seemed excited by the prospect of this fire hose of information.  At the same time, there was general agreement that social media generally is very heavy lifting indeed if you want to include it in an investment process.  How do you know a tweet is positive, or sarcastic?  Sure, a 12 year old knows.  But a computerized algo reading it?  As if…
...MORE