Quantitative analysis has part to play in world of big data
According to IBM, we create 2.5-quintillion bytes of data every day, with 90% of the world’s data having been produced in the past two years alone. Businesses across the spectrum, from social media and entertainment to banking and investments, have recognised the benefits of harnessing big data.
Advances in intelligent technologies have resulted in data screening tools (quantitative analysis) gaining a strong foothold in the investment management industry. When it comes to finding good companies in which to invest, information and timing are key. This requires the ability to speedily process huge volumes of information from multiple sources.
A quantitative approach uses mathematical and statistical modelling that collects immense volumes of data at lightning speed to help identify good investment ideas and assess portfolio risks. To put it in perspective, more than 16-million discrete pieces of information feed into constructing a portfolio from a 4,000-stock universe. Quant analysts are often described as data analysts working in finance, as they need to be highly skilled in maths, statistics, computer science and finance.
When it comes to big data and machine learning, public debate tends to pit humans against machines, reinforcing the stereotype of an “us versus them” scenario, rather than entertaining a “marriage of two minds”. Even within the asset management industry, it is common to find that active equity managers only employ quantitative analysis as an initial screening tool to identify good investment ideas based on a specific set of criteria. So, quants are often used as a filter to narrow a large investment universe, after which fundamental analysts take over.
In our view, each approach has key strengths. Essentially, we capitalise on the best attributes of both. Quantitative screening offers discipline, repeatability, objectivity and efficiency, while bottom-up fundamental research provides depth, human insight and judgment.
Our quantitative stock screen research and fundamental analysis run parallel to each other, so the one process is not relegated to a supporting act: both have a star billing. The investment ideas that are identified by both our quantitative and fundamental analysts typically represent our high-conviction stock picks in the Investec Equity Fund.
For example, Anglo American and BHP Billiton came up as top picks based on our quantitative and fundamental research. These stocks both represent a material holding in the Investec Equity Fund.
As these two research processes run independently, the one may identify a stock as a good or bad investment idea, which might not be supported by the other. Both processes may fuel debate, highlighting the need for further analysis of an investment idea. This integrated approach reduces the risk of “overconfidence”, which can be a pitfall where idea generation favours only one of these two research processes.
Portfolio construction and risk management are complex processes for humans. Constructing a simple 30-stock portfolio requires managing hundreds of pieces of expected return, risk and related information, easy for a machine but difficult for a human. Some asset managers will try to manage risk by limiting the weighting of an individual stock or by imposing sector-specific exposures. We believe these measures are a blunt way of managing risk, as they constrain potential outperformance and do not consider the multiple correlations between stocks and sectors.
Proprietary quant tools allow us to combine key risk and return metrics to optimise our portfolio and maximise diversification. Our internally developed system provides crucial information to us on a pre-trade basis. For example, before we implement a trade to reduce the allocation to one stock in favour of another, the system tells us how it will affect the overall portfolio risk.
While our proprietary models have greatly enhanced the risk management and portfolio construction process, human insight and common sense remain crucial. Fundamental analysts are best placed to interpret breaking company news, market dynamics, regulatory or tax changes, and environmental, social and governance (ESG) issues.
We believe fundamental analysis and quantitative analysis have an important role to play in finding good stock ideas, as well as constructing a portfolio and managing risk.
Over the past eight years we have refined our investment process, blending quantitative analysis with fundamental insight to produce more consistent investment returns for our investors.