Thursday, April 14, 2011

How quants think

Quants aren't like most of us because they think in ways that are counterintuitive. Recently, Cliff Asness explained quantitative investing by comparing the portfolio construction styles of quants and fundamentally oriented investors (or "quals"):
A qual digs very deeply into potential investments, but he can only do that with so many stocks, so he needs to have a relatively high level of conviction that he is right, since he's going to hold a pretty concentrated portfolio, say 10 or 20 stocks ... A qual needs to be careful about not making mistakes--one bad mistake in a 10-stock portfolio can get ugly!" He continued: "A quant, on the other hand, has the ability to study thousands of stocks at once, and thus can hold much more broadly diversified portfolios. Because quants hold so many stocks, ones that are even slightly misvalued may still make sense ... If you can find 500 stocks to bet on where each has a 51 percent chance of beating the market, then through diversification, the odds of your overall portfolio start to look pretty good.

Asness was really re-stating Richard Grinold's Fundamental Law of Active Management which states, in effect, that you should size an investment bet according to the size of your "edge".

How much should you hold of a stock ranked "sell"?
Consider, for example, a large cap stock (e.g. Apple) that is ranked "sell" comprising of 12% of the weight of the benchmark (a revised NASDAQ 100). How much of it should you hold?

For a fundamental investor who strenuously researches the company, the answer is a zero weight. For a quant who holds a large number of positions in his portfolio and depends on a statistical edge in stock picking, the answer is likely a non-zero weight, equal to the index weight (12%) less the size of the bet (probably between 1.5% and 3%). In the latter case of the quantitative investor, the correct answer is likely between 9.0% and 10.5%.

Remember your investment philosphy
Although there are some practical problems with the application of Grinold's Fundamental Law, the lesson still holds: bet according to the size of your edge.

For investment managers, this means that you should remember your marketing material when you construct a portfolio. Recall that investment managers are usually evaluated on the 4Ps:
  • Philosophy: What is your edge in the market?
  • Process: How do you implement your edge in the market?
  • Performance
  • People
What is your edge and how do you implement it?

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