Quantitative investing needs to  change, and should do so by scaling  up to produce more proprietary  data, reducing excessive numbers of  signals and becoming more “market  savvy”, according to the global head  of equity research at BlackRock,  Ronald Kahn.  Mindful of the terrible press  that quants received when most  practitioners recorded substantial  negative returns in August 2007,  Kahn now seeks to differentiate  ‘scientific investing’ from  ‘quantitative investing’.

He laments that the latter  has come to mean “optimising  portfolios with forecast returns  proportional to a few well-known,  publicly available financial ratios –  book-to-price, earnings-to-price,  price momentum and analyst  estimate revisions…in its worst  implementations, it mindlessly  searches for patterns in historical  data, to extrapolate into the future.”  That’s not to say all generic  signals should be ignored – Kahn  points out that book-to-price was  a great predictor of global market  recovery in March 2009 – but he  believes that ‘scientific investing’,  as a superior sub-set of quant,  should focus on ”identifying new  investment ideas and continually  improving their implementation”.

However, a “new idea” should  not be confused with “just another  signal that captures a value  premium in a slightly different way  to all the others”, Kahn said.  “Scientific investing is not just  about maths, you know, inverting  a matrices. If algebra could be  converted into alpha, quants would  always outperform because we  can all do it. The key is coming up  with ideas, grounded in economic  sensibility, and running a variety  of empirical and analytical tests  against them.”  Economic sensibility was a  priority for Kahn’s ‘Scientific Active  Equity’ team at Barclays Global  Investors, long before it became a  part of BlackRock following the big  merger last June.

A classic example of a new idea  which “grew from a hypothesis  grounded in economic sensibility”,  according to Kahn, was a ‘quality  of earnings’ signal which broke up  a company’s reported earnings into  a ‘cashflow’ piece and an ‘accruals’  piece.  “Richard Sloan had done some  great work on this in 1996, yet  everyone but us was ignoring it, and  looking at earnings in totality.”  Sloan had shown that the  higher the proportion of the cash  component of earnings to the  accrual component, then the greater  was the persistence of earnings  performance.  Economic sensibility is one  thing, however the quantitative  manager performance crisis, from  which Barclays/BlackRock was not  immune, had shown that it needed  to be accompanied by market savvy.

“You need to be aware of the  prevailing market environment and  whether it supports the ideas you’ve  got,” Kahn said.  Any signal tied to analysts’  revisions, for example, needed to  recognise that sell-siders were “slow  to update their expectations” in  more volatile markets such as those  recently experienced.  “The classic example was two  days before Lehman Brothers  collapsed, the analysts revised down  their financial year one estimates  for Lehman earnings – but not for  financial year two”.  Kahn said the BGI merger  with BlackRock had helped his  scientific team gain this vital market  savvy, encouraging interaction  with fundamental analysts and  broadening perspectives.

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