Quantamental investing could best create value for pensioners
New method leverages the power of data without abandoning the positive aspects of fundamental analysis
For many South Africans, the only wealth that they would be able to accumulate over a lifetime of hard work is the balance of their pension fund.
It remains therefore essential that we continue to ask what strategies and tactics investment professionals employ to not only protect the wealth of individual pension fund members but also to best grow it. The two most well-known policy strategies we have available are active investment management and passive investment management.
As far back as 1974, Keith Ambachtsheer, currently a professor of finance at the University of Toronto, observed: “Active management is under serious attack because, as evidence shows, it has produced not overperformance but underperformance.”
This statement still rings true today.
Active management finds itself under pressure from passive funds because most active managers have produced long-run underperformance of their benchmarks. Competition from passive funds is forcing active managers to justify not only their fees but also their existence. In this context, it is vital that active managers evolve and capitalise on advances in technology for the delivery of better client outcomes.
Active management is the process of building an investment portfolio where the weights of individual securities differ from the market. In the long run, investors expect a reward for taking on more market risk. Because of the higher risk that comes with investing in equities, they expect a higher return for investing in equities as opposed to cash.
Unfortunately, the same relationship does not necessarily hold when applied to active management. Investors will not always receive a higher return for building a portfolio that looks very different from the market.
Active management is about one thing — information. Active managers believe that they can access and process information better than others to build investment portfolios that add value.
However, critics believe the failure of most asset managers to outperform their benchmarks is evidence that active management is a futile exercise. This view has led to the increased popularity of passive funds.
Of course, traditional approaches to active management have weaknesses that may often lead to poor outcomes for clients. The two main methods used in the selection of investments in actively managed portfolios are fundamental and quantitative.
For many years, analysts and portfolio managers have conducted fundamental research. They make buy or sell recommendations based on their knowledge of companies. This approach is highly subjective and often leads to errors. For example, analysts are generally overconfident and believe their forecasts to be more accurate than what they are.
Eric Sorensen, of Boston-based PanAgora Asset Management, which has over $46bn assets under management, argues that fundamental active managers cannot analyse a vast number of opportunities. Their analytical framework is also susceptible to emotional errors such as falling in love with the share of a listed company. Unless fundamental portfolio managers find ways to reduce such errors, the trend of disappointing client outcomes may continue.
Quantitative portfolio managers try to predict future prices of securities by looking at historically recurring patterns, based on analyses of various datasets. This approach is not susceptible to the emotional errors of the fundamental analyst. Unfortunately, it does not have the human insight required to adapt to changing trends.
For example, most quantitative funds were slow to react to the spike in volatility during the 2008 global financial crisis. The funds were still making decisions based on the data observed during prior years and were unable to realise that the environment had instantly changed. Quantitative investors must explore ways to incorporate human foresight into their strategy if they are to enhance their chances of delivering outperformance.
It’s possible for active managers to develop an approach that does not have the weaknesses of either the fundamental or quantitative methods. Globally, a new breed of active managers has emerged. They have taken advantage of the rapid advances in technology to develop an investment approach that harnesses the best elements from the two traditional methods.
Quantamental investing is an approach that combines quantitative and fundamental techniques to make superior investment decisions. It leverages the power of data without abandoning the positive aspects of fundamental analysis.
For example, a quantamental investor might use a statistical model to generate investment ideas, but use fundamental analysis to decide which of these ideas to include in a portfolio. It reduces the level of bias that affects the generation of investment ideas while retaining the human foresight that is necessary to capture new trends.
Today, with the advances in technology, analysts can use sophisticated models to tap into multiple data sources. Access to unique data gives them an information advantage over those who remain rooted in traditional methods.
It is, therefore, possible to construct an approach that has numerous strengths relative to conventional methods. This is the quantamental approach that combines the best of both worlds.
In conclusion, active management faces numerous challenges due to the delivery of disappointing outcomes for clients. In response, investors are beginning to favour the use of passive funds.
However, before sounding a death knell for the active-management industry, investors should consider improvements that can be made to traditional approaches. Quantamental investing harnesses the benefits of the conventional investment approaches without the baggage that comes with it.
Active managers who use the same tools and techniques from the past will limit their ability to deliver investment outperformance. As Sorensen puts it: “New approaches with depth, breadth, and focus will be the hallmark of tomorrow’s successful active managers.”
Moreover, as we continuously seek ways to improve the financial situations of our clients, this approach may deliver a positive benefit for many pension fund members.
• Rabali is chief investment officer at Lima Mbeu Investment Managers, which is 50% owned by Patrice Motsepe-backed African Rainbow Capital