The increasing use of data analysis in the investment industry is fuelling the popularity of quantitative funds – and more financial advisors are turning to these computer-driven strategies to make investment decisions for investors’ portfolios.
The securities held in quant funds, as they’re best known, are chosen by advanced mathematical and statistical models as well as data analysis. Traditional investment funds rely on qualitative calls, such as assessing management commentary or the success of a company’s new product, to make these decisions. In effect, quant strategies rely on computers to slice and dice information based on rules set by humans, such as price or trading volume.
Although the use of computers to make trades dates back decades, technological advances are driving the growth of quant investing. Investment funds managed by computers account for 35 per cent of the U.S. stock market and 60 per cent of both institutional equity assets and trading activity, according to a recent article in The Economist.
Similar to failures of some funds powered by human decision-making, not all quant funds are successful, but advisors are looking at ways to incorporate quant strategies to diversify clients’ portfolios and reduce risk.
Quants are considered less risky in part because they remove human emotion from investment decisions.
“A lot of work on behavioural economics suggest many investors, left to their own devices, will make poor decisions because of the biases we tend to have, such as overconfidence,” says Steve Forester, professor of finance at the University of Western Ontario’s Ivey Business School. “The spirit of quantitative models is to step aside from the emotions and have some other logical basis for making investment decisions.”
There’s often a misconception that quant funds are passive because computers make investment decisions, says Mark Stacey, head of AGFiQ Portfolio Management, AGF Management Ltd.’s quant investment platform.
“[Quant investing’s] not passive, it’s active management,” says Mr. Stacey, who is also senior vice-president, head of portfolio management and co-chief investment officer (CIO) at London, Ont.-based Highstreet Asset Management Inc., an AGF subsidiary. “Even though we are using data computing power, there’s always a human element in the creation and oversight of the models. ... It’s based on fundamental factors.”
Mr. Stacey says quant funds are transparent and can help lower investment risk.
“Quantitative processes are constructed with risk in mind,” he says. “Quants understand the risks we are taking ... and how much risk.”
Dan Hallett, vice-president and principal at Oakville, Ont.-based HighView Financial Group, says his firm uses a quant strategy for part of its client portfolios.
“Virtually any quant strategy is an active strategy. It’s a way to find stocks with certain characteristics that are expected to outpace the broader market,” he says. “Advisors may choose quant strategies when looking for certain performance characteristics and as long as they interact well with other pieces of the portfolio.”
Generally speaking, the quant model is good for buying relatively large companies with higher trading volumes, he says, but not as well-suited to less liquid and more complex investments such as preferred shares, for which human involvement in the trades and selection is often favoured.
Although quant strategies can be more cost-efficient, Mr. Hallett says they’re not always the best option. He cautions against funds that might seem “too gimmicky,” which is usually a product designed to sell and not necessarily to deliver long-term performance.
“There are so many strategies and products available,” he says. “Advisors need to tread carefully in terms of which products they use. ... It’s incumbent on advisors to be smart about the design of a quant strategy, how the products fit in a portfolio, and due diligence and oversight when selecting the products.”
Noah Solomon, president and CIO at Outcome Wealth Management, uses quant investing exclusively at his Toronto-based firm.
He likens the strategy to Amazon.com Inc.’s use of algorithms to determine consumers’ preferences based on past purchase patterns.
“Amazon uses it for retailing reasons. We’re using it for investment reasons,” Mr. Solomon says. “You’re looking to play the odds on historical relationships and patterns. ... [Computers] look through reams of historical data to find relationships and patterns. Through these relationships and patterns, you derive signals. Those signals are the gold you use to invest.”
Much like Mr. Forester, he also points to the benefits of removing human emotion from the investing process, which can cause investors to make rash decisions they may regret later.
“Our emotions and cognitive biases aren’t our friends when it comes to investing," Mr. Solomon says, adding that humans can’t analyze the volume of data that a machine can.
In addition, Mr. Solomon says quant funds have other significant benefits – such as portfolio diversification.
“People underappreciate that they need to diversity in terms of style” as well as by asset mix and geography, he says. “[Advisors] should have a value manager, a growth manager and a quant manager ... because it diversifies you by style, which should smooth out volatility and diversify your portfolios to get better, risk-adjusted returns.”
The challenge is some advisors, especially those who have been around longer and used to traditional human-led investing strategies, don't understand quant funds, Mr. Solomon says.
“They’re used to thinking in terms of a company – if they like the management and if they think the next iPhone will be a success or not, for example” he says. “It’s a completely different way of thinking about the world, which is challenging when you’ve been taught to look at the world in one way for a long time.”
It can also be difficult for some advisors to communicate quant strategies to their clients.
“The economic benefits are clear, but there are some challenges. Advisors have to get their head around these things and distill them in a common-sense way for their clients,” Mr. Solomon says.
However, Mr. Forester says advisors should be cautious when using quant strategies for clients – including ensuring the type of investing aligns with investors’ beliefs and investment philosophies.
For example, he says a quant fund wouldn't be suited to investors who believe in doing deep dives on companies, including analyzing management discussions, assessing corporate governance issues such as board diversity, or judging a firm based on its environmental footprint.
"Clients should absolutely know what they’re investing in,” he says. “If things don’t go as expected, advisors are setting themselves up for if not legal action, but disappointing clients.”