Trading Like a Quant

Employees are increasingly concerned that robots are coming to take away their jobs. This is being seen in factories, restaurants and retailers. Driverless cars and trucks threaten the entire transportation industry. While many think that only jobs paying low wages are at risk, that is not the case.

Many of Wall Street’s jobs are threatened by robots, including some of the jobs with the highest pay. For many years, successful hedge fund managers have been rewarded with annual compensation measured in hundreds of millions or even billions of dollars. Now, their jobs may not be so secure.

On Wall Street, the robots are called quants and they are getting better and better. Quants apply quantitative investment strategies. As their skills improve, investors are trusting them more. The result is likely to be less job security for traders.

The threat to Wall Street is growing. A recent report from Barclays called the time frame from 2013 to now the “resurgence of equity quant.” In that report, Barclays estimated that more than half of all investors (54%) will be dedicating some money to quant strategies this year. The number of investors using quant strategies is growing rapidly. It is up from 38% two years ago and 48% last year.

Investors following quant strategies may be trying to duplicate the success of Renaissance Technologies’ Medallion Fund. This hedge fund is based 100% on models that find buy and sell signals hidden in the market action.

According to Bloomberg, the fund “has become probably the world’s most successful money machine. Powered by millions of lines of computer code, it has made about $55 billion over the past 29 years, thanks to average returns after fees of an astounding 40 percent.” A $1,000 investment in the fund at inception would be worth more than $13.8 million at that rate of return.

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Source: Bloomberg

There will probably never be a fund as successful as Medallion but its success demonstrates the value of following quant strategies. We have long found value in this approach and present quant strategies almost every week in this blog.

Quant Strategies Range From Simple to Complex

Just as with value investing or with technical approaches to trading, quant strategies run the gamut from simple ideas to complex strategies. For example, the Dogs of the Dow strategy is a simple quant approach.

The Dogs of the Dow buys low priced stocks in the Dow Jones Industrial Average and holds them for one year. The strategy is driven by rules dictating what to buy, when to buy, when to sell and how to reinvest the proceeds from the sales.

That’s all a quant strategy is. The strategy includes detailed rules that are based on objective metrics.

Investors often make decisions based on subjective factors. For example, they may see a news story about the approval of a new drug. Believing the drug will be a blockbuster, they buy the stock. They may or may not be right. But their decision is based solely on their subjective evaluation of the news in this case.

Objective strategies consist of rules all investors would achieve substantially the same results with. Differences in execution costs and management fees could lead to small differences in returns for funds employing the exact same strategy.

Quantitative strategies are objective. This makes them immune from emotions. A quant fund will never sell at the bottom of a market panic unless it has been programmed to do so. The rules are all defined in advance.

In our blog, we often present examples of quant strategies. We frequently do so relying on a simple and free screening tool available at FinViz.com. This is an objective tool because everyone entering the same filters will receive the same buy list. Decisions are then data driven rather than emotional.

An example of this technique is shown below. In this case we are looking for stable companies that are members of the S&P 500 with high dividend yields of more than 4% and low prices below $20 a share. We also want the stocks to be trading on low volume, indicating investors may be ignoring value.

This screen found four stocks. To be a strategy, we would need to add sell rules. We could decide to rerun the screen every three months and reallocate investment capital based on the new results. That’s all it takes to have a simple quant strategy.

Advantages and Disadvantages of Quantitative Strategies

Quant strategies have several advantages over more subjective investment strategies. First of all, they are immune to emotional responses. Many investors sold in March 2009 as stock markets bottomed. Or, they sold a few weeks after the bottom, expecting the bear market to resume. The chart from that time might still stir up emotions for some investors.

While the advantage of the quant approach is that it eliminates emotional responses, it only does so if traders follow the rules with discipline. This means the system only delivers results if all of the trades are taken.

This might sound easy but is difficult to do in real time. If the rules say to buy in the midst of a market selloff, traders might find it difficult to enter orders. They may decide to wait a few days and this, of course, can harm performance in the long run.

While buying in a bear market presents an obvious dilemma, it can be equally challenging to accept signals in individual stocks. For example, you may have a bearish outlook on a sector. Or, you might believe a stock is overvalued. But, if the quantitative signals say the stock is a buy, it is important to take all of the signals.

This can be difficult for many investors. They may have a strong feeling on a company or a sector. One way to address that problem is to program into the strategy rules that the sector or stock is to be avoided. However, if that is not done in advance, the rules should be followed as they are written.

For many investors, quantitative strategies can boost profits. Results like those achieved by Renaissance Technologies are rare, yet possible. The firm does not speak publicly about its strategies but they appear to employ at least some short term strategies. They also seem to use a great deal of leverage.

Leverage can boost gains but also increases risk. Here, again, quantitative testing can help. A quant strategy can be back tested, or simulated on historical data. This provides insight into the type of performance you can expect in the future.

While this is another advantage of quant strategies, it is important to remember the future will always be different from the past. It is best to assume the system will have more risk in the future than it had in the past, especially of using leverage. This can avoid facing a margin call at the worst possible time.

In the long run, a quant screen can be helpful. We will continue sharing ideas for these strategies in this blog. We will always present all of the stocks that pass the screen and are not recommending the individual stocks when doing that. We are showing the results of the strategy.

Our articles are also intended to be educational. By explaining the logic behind our screens, we are demonstrating the process to develop a quant strategy. With the tools we explain and illustrate each week, you can then develop your own strategies and find your path to investment success.