Often touted as the data-based approach to reaping alpha by exploiting human biases, quantitative investing is having somewhat of a renaissance after a tough period of underperformance.
Quant investing refers to a broad universe of algorithm-driven strategies, ranging from statistical arbitrage that profits from fleeting price differences, to factor investing, that benefits from identifying persistent marker drivers.
Working with a rigorous performance test system, Australian super funds consider quant investing a desirable middle ground between passive and active management, as the method bears a tolerable level of risks, fees and tracking errors.
US or European pension funds’ incentive to select quant managers is less to do with regulatory constraints, says Robeco’s Netherlands-based head of quantitative investing and research, Weili Zhou, but quant investing has been a pension fund favourite for decades.
She tells Investment Magazine that when Robeco’s first quant ranking was made more than thirty years ago, it played little more than a supporting role for the fundamental investment business.
“We [the quant team] were always just working on an advisory model,” she says.
But it all changed in 2002 when a Dutch institutional client presented with a request for a more benchmark-driven proposition, which was different from the popular high-conviction portfolios where managers took concentrated bets on a select group of companies, Zhou says.
“This client came to us and asked if it’s possible to do a relative risk of only 1 per cent, which was significantly lower than the typical 5 per cent-plus fundamental strategies had,” she says.
“If I use the term nowadays, they wanted an enhanced indexing strategy. And the only way to do it back then was for the quant team to do it in a very systematic and engineered way.”
Over time, quant strategies have developed with pension funds’ needs, such as the European focus on ESG and SDGs. It is now possible to integrate signals such as sustainability risk constraints into quant portfolios, which has allowed for a greater level of customisation for funds.
“What you see very often [with overseas pension funds] is that there’s a core/satellite allocation- core being the benchmark-like, low tracking error and low fee allocation,” she says.
“That would be roughly 80 to 70 per cent of total allocation.
“On top of that, you can have some satellite in a low-performance correlation with the core, so that you diversify the risk profile of the total portfolio, with some higher alpha and tracking error type of strategies to top it up.
“Ultimately, the fiduciary responsibility is not only the impact or sustainability, but also the financial return for all the beneficiaries.”
Spring is here
Quant has faced doubts over the years like all investing methods, especially in the two years leading up to 2020, which has been dubbed “the quant winter” in the media.
Many factors in quant’s factor-investing subdomain identify market inefficiencies and biases to make a buck.
One of these factors is “value” – investors’ tendency to chase expensive stocks with long-term growth prospects but shun cheap ones – whose return was so unsatisfactory during the two years that it overwhelmed the contributions from the other factors.
“It was such an extreme market situation [during the quant winter] that only a very small number of stocks with very peculiar characteristics were working, which is mega cap growth stocks – the Magnificent Seven, for example,” Zhou says.
This made it especially challenging for quant managers to exploit good opportunities, since it was difficult to reap performance in other pockets of the market, and many quant strategies’ base approaches were very diversified.
“This is why, at the time, you saw a lot of fundamental thematic strategies doing well… but this situation is not sustainable,” Zhou says.
It was a tough time for many quant shops, as they have taken a double hit from both performance and profitability loss. But, at least according to Zhou, the strong recovery of quant strategies between 2021 and 2023 shows that the winter is very much over. Robeco’s own quant strategies held up especially well in stressed equity markets such as China where many hedge funds and fundamental investment approaches are struggling now.
“I think the lesson for quant investors or factor-based strategies [from quant winter] is to further diversify on alpha sources,” she says.
“We can no longer only look at the five, six main cylinders we have – the more engines the better.”
This also includes an increasing focus on emerging equity markets and other asset classes, such as fixed income and credit, Zhou says, where performance drivers are not so correlated to what’s happening in developed equity markets, especially the US.
“I think one temptation quant would usually face is to repair the very last drawdown. One might think: ‘value is not working now, let’s turn it off,” Zhou says.
“But the systematic approach is really to defy emotion and adhere to the long-term evidence and underlying economic drivers.
“Yes, it is stressful to face underperformance as an individual, even more so when you see others capitulating. But only those who are able to stick to their guns can ultimately harvest the premiums.”
This article is a part of the partnership between Robeco and Investment Magazine.
