Man vs. Machine: An Analysis of Fundamental and Quantitative Strategies

  print  

"Quant funds" are the subject of significant interest, debate, and controversy in the institutional investment world. Clearly, there has been massive growth in hedge funds that pursue quantitative strategies in many styles, including global macro, equity long / short, and others. In August of this year, the public press seemed to jump to the conclusion that quant funds were the main driver of the market turmoil.

Many plan sponsors and other investors have predisposed notions about quantitative managers. Fundamental analysts may view their quantitative competitors as computer geeks that have no basic understanding of the economic or market factors that move stocks. Conversely, quants think fundamental analysis is subject to human emotions, as well as too time-consuming and unreliable.

Once the dust settles, we believe it is worthwhile to perform an objective analysis and attempt to answer some basic questions: How are quantitative funds different from fundamental funds? How are quant funds likely to perform over the long term and in various market conditions? How should plan sponsors evaluate and select quant managers in the context of their overall portfolios?

In our view, both quantitative and fundamental strategies can add value to an overall portfolio. In the last five years, particularly the most recent quarters, fundamental strategies have generated higher returns than quantitative strategies. However, quantitative strategies have generated higher risk-adjusted returns and better downside protection. Also, quantitative strategies tend to have lower fees. We believe plan sponsors must analyze the details of any individual quantitative fund, and consider how that fund is likely to perform in various market conditions.

A Brief History of Quant

Quantitative analysis is not a new phenomenon. The practice of applying mathematical formulas to the valuation of stocks and bonds began in the early 20th century. In the 1950's and 1960's, quantitative analysis flourished in the academic community with the work of Harry Markowitz, Robert Merton, and a host of others. Over the past 50 years, quantitative analysis has become a mainstay on Wall Street.

The universe of quantitative managers includes a wide range of strategies pursued by both hedge funds and traditional managers. Many quant hedge funds, such as AQR, Highbridge, and Renaissance Technologies, have attracted significant institutional assets in recent years. Also, assets in long-only equity funds that follow quantitative strategies have tripled over the past four years to more than $60 billion, according to some estimates.

Investment managers may use quantitative analysis to varying degrees. In general, quant funds employ mathematical formulas and computer models to sift through reams of data and make investment decisions. The computer models may utilize any combination of fundamental, technical, or other factors. There are some quantitative managers who use a pure "black box" approach, and simply buy the securities that their computer models dictate. Alternatively, many asset managers use quantitative screens to reduce a large investable universe into a smaller group of stocks, and then apply fundamental analysis to decide which stocks to buy. Recently, investment managers have introduced a plethora of "hybrid" strategies, such as 130/30 funds.

Mixed Results

In order to compare and analyze relative performance, we separated managers into Quantitative and Fundamental groups based on their self-described "Primary Investment Approach" in the eVestment Alliance universe. Using this broad framework, we analyzed the results of several hundred investment managers over the past decade. Moreover, we calculated and compared a variety of risk measures and other data relative to the two groups of managers.

In the table below, we summarize the relative performance of quantitative and fundamental strategies for domestic equity managers.

Quantitative vs. Fundamental Managers

Source: JPMorgan Investment Analytics and Consulting, eVestment Alliance

As shown above, fundamental strategies have performed better than quantitative strategies in the most recent quarter and year. Over longer periods of time, the relative performance of quantitative and fundamental strategies varies widely.

Interestingly, quantitative strategies have generated better risk-adjusted returns. In the chart below, we illustrate the relative Sharpe Ratios for quantitative and fundamental strategies in the domestic large cap, mid cap, and small cap categories. Sharpe Ratio equals excess return per unit of risk.

Sharpe Ratio

Source: JPMorgan Investment Consulting and Analytics, eVestment Alliance

As shown above, quantitative strategies generated higher Sharpe Ratios in the large cap and mid cap categories, while the Sharpe Ratios for small cap strategies are essentially the same.

Interestingly, quantitative strategies seem to offer enhanced downside protection. In our analysis of large cap managers, the quantitative strategies as a group captured 87% of downside markets, while fundamental strategies captured essentially 100% of downside markets. The magnitude of downside market capture was similar for mid and small caps. As such, it appears that quantitative strategies have exhibited an ability to cut their losses and manage their risk exposure in bear markets.

One explanation for the recent underperformance of quant funds is overcrowding. In the eVestment Alliance database, the number of domestic funds pursuing quantitative strategies has nearly tripled over the past decade to more than 700 quantitative strategies in 2006. Clearly, there is a broad range of quantitative strategies with a multitude of philosophies. Based on our analysis, the correlation of returns for quantitative strategies as compared to the overall universe of managers has converged over the past two decades, to a correlation of close to 1.0 at this time. The sheer number of quantitative funds suggests that it has become more difficult to outperform.

In addition, we also compared the average fees for each type of investment manager. In each category, the average fee for quantitative strategies was approximately 10 basis points lower than the average fee for fundamental strategies. Ultimately, the lower fees of quantitative strategies may be attractive, particularly when alpha generation is hard to come by.

International and Emerging Markets Managers

It is interesting to compare the use of quantitative strategies in different geographic regions. In international and emerging markets, the quantitative strategies may be newer and less thoroughly developed than in the United States. Also, quant funds in emerging markets may be limited by the availability and quality of data. Investors may see this either as a limitation or as an opportunity, depending on their perspective.

In the table below, we illustrate the relative performance of quantitative strategies versus fundamental strategies for international and emerging markets managers over the past decade.

Quantitative vs. Fundamental

Source: JPMorgan Investment Analytics and Consulting, eVestment Alliance

As indicated above, the quantitative managers enjoyed strong out-performance from 2001 to 2004. In the most recent two years, however, the performance has been mixed.

Indeed, our analysis indicates that quantitative managers in the emerging markets equity category posted higher returns than fundamental managers in the most recent 5-year period. Moreover, the quantitative managers posted a meaningfully higher Information Ratio, or Active Return divided by Active Risk - 0.66 for the quants versus 0.32 for the non-quants. It should be noted that the group of quants in the emerging markets is small, potentially making it more likely to stand out in a less crowded field.

Devil in the Details: Factors to Consider in Choosing a Quant Manager

At this point, there are more than 800 quantitative strategies pursued by traditional managers. Furthermore, there are a plethora of quantitative hedge funds and other alternative strategies. In our view, plan sponsors must analyze the details of each fund and make an investment decision based on the specific characteristics of its strategy. Nonetheless, we believe there are some key benefits and differences of each investment style. In the table below, we provide a general comparison of quantitative and fundamental strategies.

Quantitative vs. Fundamental: A Comparison

Source: JPMorgan Investment Analytics and Consulting

Importantly, plan sponsors should be aware of the broad factor exposures of a quantitative strategy. There may be unintended sector, style, or other exposures inherent in any particular quantitative strategy. For example, let's say the process of a quant fund is to buy stocks with a history of increasing dividends. This factor may omit technology stocks or small cap growth stocks. Plan sponsors should be aware of the probable exposures inherent in any quantitative strategy.

Another factor that plan sponsors should consider is style drift. High-quality quantitative managers constantly analyze and refine their processes and algorithms. Typically, quant managers modify and enhance their computers systems to adapt to changing market conditions. Over time, a fund's style may drift and lead to unexpected and unintended exposures.

Furthermore, plan sponsors should consider several issues when analyzing the universe of quant funds. When evaluating the historical performance of any fund, it is important to remember survivorship bias. Most current databases include only the funds that have performed well, and historical results may be over-stated. Also, quantitative managers often use back-tested results in connection with their marketing materials. Of course, managers can present hypothetical historical performance in the best possible light.

Conclusions

In our view, plan sponsors should consider the merits of both quantitative and fundamental strategies. In the recent turbulent market conditions, fundamental strategies have performed better than quantitative. It appears that fundamental strategies have outperformed in the most recent 5 year period. However, quantitative strategies do appear to offer downside protection and higher Sharpe Ratios. Also, quantitative strategies may have lower fees than their fundamental competitors.

In our view, there are benefits and costs of investing in both quantitative and fundamental strategies. Plan sponsors should closely analyze prospective quantitative funds in the context of their overall portfolios. In all, we believe it is worth the effort to analyze quant funds and consider allocating a percentage of portfolio assets to this group of managers.