Exploring the value of niche quant investing strategies

As a result of digitalisation becoming a global trend in modern times, quantitative investing has seen a growing prevalence in hedge funds.

Throughout the coronavirus pandemic, market volatility has been relatively dramatic and unprecedented in several financial markets. As a globe, overall GDP growth has suffered immensely yet we observe that emerging market stocks have been rebounding. In the span of 22 days, the S&P 500 fell 30% in February 2020 which set a record high for a speedy sell-off even when compared with those of the Great Depression era. As investors continually thew away stocks due to fears of delayed central authority intervention, many market indexes tanked significant basis points which in turn pushed benchmarks down. For the UK's blue-chip share index known as the FTSE 100, the two days leading up to February 25th saw £100bn wiped off. Many quant hedge funds jumped at this opportunity to generate alpha returns by turning to tech stocks such as Tesla and Zoom with the hope to profit in recovery.

Whilst the market punished weak ESG factors in some economies, others have thrived and will continue to do so in the years following this pandemic. The American financial services firm Morningstar in Q1 2020 published inflows of around $10bn USD for sustainable open-end mutual funds and exchange-traded funds which was a significant amount, driven by quant investing. Such is a prime example for people and firms needing to stay versatile in uncertain times which give rise to new trends. Traditionally, fundamental investing strategies have prevailed but now investors are starting to turn to quant investing strategies which have particularly shone in the wake of coronavirus. It is widely agreed that quantitative approaches can help streamline both investment decisions and ESG factors implementation. Having more robust frameworks for analysing relative fund performances will drive returns moving forward.

I'm too embarrassed to ask - What is quant investing?

Asset managers have varied ways of investing to maximise investment gains by aiming to outperform the relevant fund benchmarks. The ideal scenario is when returns are high with minimised downside risk, which is often targeted via quant investing strategies.

Over the past half-century, personal computers have become ubiquitous due to technological innovation making production less costly and so retail selling more affordable. When it comes to investment management, data analysis to manage risk is typically used to assist with investment decisions. Taking this another step further, some hedge funds that utilise quant investing to focus on the statistics. This removes the aspect of emotions and so a decreased amount of risk in the fund as portfolio managers can centre in on the scientific backing, without necessarily going for the investment strategy with the seemingly highest return. As a result of digitalisation becoming a global trend in modern times, quantitative investing has seen a growing prevalence in hedge funds. These funds typically charge investors extortionate fees up to 20%, a credit to their specialised strategies which use quant models.

Firms have been using these quant investing strategies?

Just as with ESG factors implementation seen in the financial services industry for asset managers, quants have had to adapt during 2020 to improve their financial models. After all, quant investing is mostly drawn from real data to predict future trends. Both quant finance and calculus have resulted in tools such as the Black Scholes option pricing formula that allows investors to better price options and develop strategies to keep liquidity in check. Many companies have begun to look towards stochastic simulations along with stress testing to soften the financial blow of unfamiliar events.

Some quantitative hedge funds actively blending in these strategies, including DE Shaw and Capula, have delivered favourable net returns for investors in 2020 - namely DE Shaw whose flagship fund Composite alone offered 19% gains. Its attractive net Sharpe Ratio of 1.83 is demonstrative of its success in achieving a preferable risk-adjusted return. This portfolio has been considered superior relative to many peers throughout the past year, due to lower correlation with major asset classes. The JP Morgan Investment Analytics team recently performed a study of some different investment strategies, and their findings showed that on the whole, the portfolios that have quant investing strategies exhibit a higher Sharpe ratio on the mid and large-cap stocks.

Meanwhile many other hedge funds have been battered as they needed a more refined usage of big data analytics. One that experienced hardship was David Harding's Winton firm which is one of the largest hedge funds in the UK. Assets under management plunged over $26bn USD for the firm with a singular focus on statistical inference. Such quant firms have observed the shortcomings and risks in having a rigid quant investing style, and have suggested that a combination with traditional strategies for proper diversification is a better idea. It appears that just as we noticed in the global financial crisis throughout 2008 and 2009, quant investing strategies are inferior to those of traditional investing when markets are volatile as steady gains are less likely. Naturally, we will see a combination of these strategies continue to persist as markets strive towards a post-pandemic recovery.