Quant plus fundamental: two methods are better than one

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When it comes to market forecasting, too many people thinking the same thing is almost always cause for concern. That said, in the current environment, an enormous amount of creative optimism is required to formulate a contrarian view.

Central bank activity saved the financial system from collapse in 2008 and stimulated the second-longest bull market in stocks. Unfortunately, the tools at their disposal were insufficient to engineer a return to high and inclusive rates of economic growth or durable financial stability. Terms like the New Normal, the New Neutral, or Secular Stagnation describe a global economy with sluggish growth, rising inequality, high unemployment and ever-increasing market volatility.

Rising demand for absolute returns

There has been significant asset price appreciation since the GFC. However, over the past 10 years, a traditional balanced portfolio allocating 60% to equities and 40% to fixed interest securities has only outperformed what most would consider a reasonable investment objective of CPI+5% in 41% of months on a rolling five-year basis. It is therefore not surprising that financial advisers and their clients are increasingly looking for new ways to build absolute return portfolios, where the investment objective is wealth creation rather than beating a traditional benchmark.

Portfolio construction, diversification, and the incorporation of alternative investment strategies all have roles to play in this endeavour. An ideal portfolio would likely contain non-correlated assets with positive return expectations. This means that all the assets in the portfolio would go up and down at different times – although the general direction would be positive. The ups and downs would partially cancel each other out and the investor would have a smooth, stable and stress free journey. Unfortunately, such assets are very difficult to come by, particularly for retail investors in Australia.

A fundamental approach to managing equity funds is normally associated with human insight and in-depth forward looking analysis across a narrow range of companies. With quantitative funds, the association is usually unbiased, disciplined, repeatable and scalable across a broad universe of stocks.

For some time, fundamental managers have recognised the value of incorporating quantitative techniques into their processes. Common examples of earlier approaches are: fundamental managers relying on quantitative screens to filter a large universe of stocks; and using multi-factor models to help managers control and eliminate exposure to unwanted risks.

Quantitative plus fundamental using unique data insights

The recent arrival of big data has ushered in a new era of investing, sometimes referred to as ‘quantamental’, which requires the seamless integration of quantitative and fundamental techniques. Obtaining valuable insights, often relating to future corporate earnings, from unrelated and unstructured sources requires the skills of creative analysts, expert programmers and significant computing power.

Twitter offers an intuitive example of this. It is now possible to obtain insights and indications of current stock trends by accessing all real-time tweets (approximately 6,000 per second) delivered via the Twitter Firehose service. People are better at many things but such analysis is beyond human capability. The demands are even greater for those managers who store tweets historically to reveal a changing pattern of sentiment and provide an advanced signal for a short term trading strategy.

The most valuable data is also the hardest to obtain and insights should be fundamentally generated from unique data sources, many of which would only ordinarily be used by the members of individual industries. Quantitative techniques are then used to scale these insights across a vast universe of industries and global stocks. Our new fund aims to deliver market neutral returns by simultaneously going long the companies with the best long-term prospects and short-selling those with the worst.

In the pharmaceutical industry as an example, the portfolio manager has developed an automated process to extract data from websites that allow doctors and patients to log complaints about the side effects of drugs. This frequently provides glimpses into future issues these companies or others providing drugs with similar chemical compositions may encounter. Trading strategies may then be developed which short sell these companies and go long on the companies marketing drugs with similar therapeutic application, but with fewer complaints.

The airline industry provides another good example of how the manager combines generally accepted valuation metrics with unique but common sense insights. In most developed countries, departure and arrival times of all flights are published electronically. If flights of a particular airline tend to take off late but arrive on time, it is likely that they have burned more fuel to catch up. That airline is thus operationally inefficient. An astute quantamental analyst can also rank airlines in order of baggage lost. Used in conjunction, these signals provide insights about future revenue because airlines with more late flights and more lost baggage are unlikely to retain their customers.

At its most simple, the quantamental approach involves two things. The first is the obtaining, aggregating and processing of information from numerous sources. The second is applying fundamental principles to generate differentiated returns. The result should be the construction of a well-diversified investment portfolio that provides superior outcomes in these challenging market conditions.

 

Adam Myers is Executive Director at Pengana Capital. They have brought the Pengana PanAgora Absolute Return Global Equities Fund to the Australian market. This article is general information and does not consider the circumstances of any individual.

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