Is a quantitative or qualitative approach better suited to today’s markets?

Quantitative

Quantitative versus qualitative? Having been an investor in the markets for close to 30 years, I have seen a pretty good sampling from both sides of the pendulum. Clearly both schools have their pros and cons, but from what I have personally witnessed, and the current global environment in which we trade, quantitative trading appears to me as the more stable.

While everyone was happy trading fundamental factors in the eighties and nineties, the first decade of the new millennium was a wake-up call to all. Were there better analytics to engage, or better analysts to employ? Is it better to employ a living, breathing decision maker, or does the very fact he is human make him susceptible to errors of emotion?

With the growth, speed and truthfulness of computers, quantitative analysis not only became more accessible, but more accurate. So is it better? In a true quantitative and systematic approach, the computers and algorithms spit out the results, and the trade is made. There is no room for discretion.

If you are adding a discretionary layer prior to trade execution, then you are filtering via human emotions, and although human emotions are not what got us into the mess of the 2000s, they certainly exacerbated its demise.

While the quantitative analysts can cover thousands of companies in absolute real-time, they don’t care about product, all they care about are the numbers. Data is fed to models or robots, and depending on the algorithmic recipe, the trade is presented. Fundamental analysts start with the premise of taking apart, and looking at the pieces of the business. The analysts may use computer programs and screen-selection, but there are a few intangible tidbits that the computer is unable to compute.

Looking over the short and long hauls, in general, fundamental shops seem to produce higher returns than their counterparts over time frames of 20 years, yet quantitative funds appear to have provided more attractive risk-adjusted returns, similar five year performance and higher Sharpe ratios while providing downside protection. I recently attended a conference in New York where the pension funds on the panel unanimously agreed that they are not searching for double digit performance, but they just don’t want to wake up way to the left of the bell curve. Protect their downside, and they are happy.

But let’s get back to the emotion. Emotion drives us in all we do. Some is apparent, some is hidden, but we are human. We are fallible. Therefore, we are irrational. Quants seek to bring this rationality into the financial arena and strengthen a world long dominated by instinct, guesswork and fallacy. This doesn’t mean that quants will ever be infallible. The scientific method is applicable to finance, but it is not as robust in the financial sphere as it is in nature. For example, there are only 10 to 20 years of recorded high-frequency data available for study in most financial futures markets, as opposed to centuries-worth in the natural world. It is, though, still a valid field of enquiry, because there is no other rational way to approach the markets.

The scientific method and statistics remain the best way to forecast the behaviour of financial systems. They also distance the investor from the emotions that undermine much investing. There are at least two basic behavioural patterns that define human investors: over-reaction to bad news and under-reaction to good news. This, at least partially explains the existence of mean-reversion and trends in the financial price data, both of which invariably lead to mistakes and losses.

Ben Graham, the father of modern fundamental analysis, warned of the danger of emotion: “Even the intelligent investor is likely to need considerable willpower to keep from following the crowd.”

Qualitative

The legendary investor Warren Buffet once declared: “If calculus or algebra were required to be a great investor, I’d have to go back to delivering newspapers.” This philosophy of investing in what you know and understand underpins many of the arguments made on behalf of those who favour a qualitative investment process.

Given that all professional investors today have access to vast amounts of data, systems and computing power, it is no surprise that there are significant overlaps between qualitative and quantitative approaches. To a greater or lesser extent, all fundamental investors make use of quantitative tools, be it from a top down country or asset allocation point of view or from the bottom up in terms of analysing corporate balance sheets, earnings trends or valuations relative to historical, country or industry averages.

The difference lies in the fact that for qualitative investors that is only part of the process while for quantitative investors it is the entire process. Qualitative investors take the numerical analysis and supplement that information with an assessment of non-quantifiable factors, in order to increase their knowledge and understanding of the investment in question. Done properly, such an approach will often provide an investor with an edge.

The areas that a qualitative investor might delve into that aren’t captured by numbers alone include aspects of economic and industrial cycles, political risk, competitive position, product strength, corporate governance and the quality of company management. Simply put, these factors can’t be easily captured by quantitative analysis. The challenge, of course, for qualitative investors is to overcome the issues presented by human emotions and subjectivity by applying both skills and logic to this information in a timely manner across a broad universe of potential investments.

One key area where qualitative approaches should prove to be superior is in identifying turning points. The history of stock markets is littered with examples where long-established trends break down and anyone extrapolating historic data would draw the wrong conclusions. Whilst quantitative investors continually revise their models and methodology, a core tenet of the approach is to use historic data to try and predict future performance despite everyone being aware of the mantra that “past performance is no guarantee of future results”.

Identifying inflection points is difficult, but the indications that something is changing are more likely to be gained from meetings with company managements, suppliers, buyers, competitors, industry experts, economists or strategists. Interpreting that information correctly is of course what sets the good fundamental analyst apart from the crowd.

In many regards emerging and frontier markets are no different from developed markets in terms of how one should go about analysing both the overall market outlook and that of individual stocks. However, emerging and frontier markets differ in terms of the quality, timeliness and availability of information. Disparities in language, accounting practice, market disclosure and corporate governance requirements are all factors that need be considered, along with the limited access to information compared to developed markets. This plays into the hand of focused, fundamentally driven investors with the local knowledge, contacts and analytical focus to exploit such inefficiencies.

It is our belief that a fundamental analysis of both quantifiable and unquantifiable factors is the most appropriate strategy to adopt. As another famous investor, Peter Lynch, put it, a good investor should always “know what you own, and know why you own it”.