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Anti-Quant Investing Manifesto Misses the Mark

Bloomberg logoBloomberg 10/6/2020 Aaron Brown

(Bloomberg Opinion) -- The most revealing sentence in the anti-quantitative investing manifesto by Sanford C. Bernstein & Co.’s Inigo Fraser Jenkins is this one: “The rules are changing for investors to a degree we have not seen in decades.” In fact, it has been almost exactly two decades since the market has displayed the behavior that made Jenkins, who Bloomberg News describes as one of Wall Street’s most famous quant analysts, an apostate:

The value strategy—buying stocks with strong fundamental value relative to price—is in massive drawdown Financial theory and time-tested principles seem to be “failing to grapple with profound changes in the global economy” “A boom in pricey tech stocks” “Narrow leadership by mega caps”

I was a quant investor during those years in the late 1990s, and I recall market analysts saying the same things. This time is different. Ignore the past. Forget diversification and value, and buy the hottest tech stocks regardless of outmoded measures like book value, earnings and cash flow.

How did that advice work out? Disastrously, of course. Tech stocks crashed and quant strategies soared. The Fama-French value factor, which lost 41% during the Internet bubble, soared 178% afterwards. (Factor investing is not complicated. The Fama-French value factor consists of buying the 30% of stocks with the lowest price-to-book ratios and shorting the 30% of stocks with the highest, rebalancing once a year.) There have been seven value factor drawdowns of 10% or more since 1963, with an average loss of 28% and an average subsequent gain of 82%.

As a market strategist paid to generate discussion and trading activity, Jenkins is professionally biased toward overstatement and dramatic reversals, but he’s smart and there is some substance in his report. The current value drawdown is deeper (57% versus a previous record of 41%) and more importantly much longer (13 years when no previous drawdown lasted even 3 years) than we have seen in the past. There are technical anomalies that are generating debate among quant researchers. Many—but certainly not all— quant strategies have disappointed over the last three years or so, and pandemic performance has not been inspiring.

So I have the opposite message than Jenkins. When equity strategists start yelling that economic fundamentals and diversification are dead, look to defend yourself against the bubble, not to try to hop on the bandwagon. And when new factors make markets particularly uncertain, get more diversified and don’t concentrate your bets.

Another important point is that Jenkins considers only U.S. large cap stock performance. If quant was really dead, it should be failing in foreign markets, bonds, commodities and other markets. In fact, many non-U.S.-equity quant strategies are working great, including arbitrage, macro, momentum and international equity funds.

I do agree with Jenkins in some areas. Blind faith in strategies that have worked well in the past is almost as dangerous as chasing whatever ideas are hot. Long-term investing principles are still sound. They have been tested for centuries in almost every market, location and era, and have strong theory behind them. But applications, such as measuring value by specific accounting measures or business assumptions, can change. A true quant is eternally skeptical, willing to let new data challenge any assumption.

Jenkins’ other reasonable piece of advice is to take macro views, or what quants call “tactical tilts.” Many quant funds offer strategies in pure quant form—where changes to the algorithms are very slow and based on beyond-a-reasonable-doubt evidence—and tactical form—where allocations and weights are tweaked systematically based on market conditions. The combination of inconsistent quant performance for three years, plus the fundamental economic dislocations of the pandemic, make me more inclined to accept tactical adjustments than I am in calmer times.

In investment and life it is important to have principles—things you believe in deeply and are willing to stick to even when they are unpopular and costly. But only fanatics make every decision a matter of principle. The basics of quant investing, rigorous and skeptical consideration of all evidence plus insistence on logical theory, are sound principles in good times and bad. But principles are only general guides. Wise investors allow themselves flexibility in execution.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

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