Tuesday, May 31, 2011

Turning beta into alpha

Joe Weisenthal over at Clusterstock recently reported that quants have become beta chasers:
In a survey of quant investors done by BofA/ML, the number of respondents who say that beta is a key factor in their stock screens, has surged overtime, from less than 20% in the mid 90s to over 70% now.

This observation confirms what I suspected all along - we have returned to a single-factor CAPM framework from a multi-factor APT framework. In other words, investment decision making has returned to either "risk on" or "risk off".

Given the current environment, I chose to turn to active asset allocation and apply a momentum model to the beta decision of others, i.e. the Inflation-Deflation Timer Model, as my principal source of alpha.

Playing poker, not backgammon
Many quants think of investing as a structured game with some randomness thrown in, like backgammon. I believe that in investing, you have to watch what others are doing as well. Don't forget that Edward Thorp, who was one of the original quants, was a poker player.

Correction: A colleague pointed out to me that Thorp was known as a blackjack player, not a poker player. Despite the incorrect analogy, I continue to believe that quantitative analysts think about the structure of the game that they are playing - which resembles poker than a structured game like backgammon or blackjack.

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