Most large active fund managers today have both fundamental and quantitative investment teams. Historically, these two groups have sat in separate silos, and for good reason: they have different approaches to the investment process and speak a different day-to-day language.
The root of the division is their respective educational foundations. Fundamental investors study economics and learn a bottom-up investment process that seeks to identify the future value of a single stock. Quants learn math and engineering and take a top-down approach to investment decision-making that starts with a wealth of market data.
However, fundamental investors have begun to incorporate more quantitative screens and models into their fundamental research as relevant data become more accessible and data science tools easier to use. Most fundamental investors today have at least one usually spreadsheet-based quantified screen, intended to flag valuation mismatches, environmental, social and governance (ESG) scores and the like, that influence their investment process. Some have many screens, and a resident quant analyst sitting next to them.
It’s a matter of evolution.
The term “quantamental” may have inspired more eye rolls than hugs in the market, but like it or not, even the most stubborn fundamental investors are becoming quantamental.
At many advanced firms, heads of quantitative research are rising to leadership positions where they are tasked with bridging the gap between the firm’s fundamental and quantitative investors, or at least leveraging the resources of both groups.
But finding common ground is easier said than done. Fundamental investors still hold most of the power within these companies and often have no interest in engaging with quants. At best, they struggle to understand the language, and at worst, they see quants as a threat. Meanwhile, true quants often find fundamental investors clinging to old and outdated ways of thinking. In fact, many quantity-only shops arose out of a rejection of the fundamental approach.
So which of the two philosophies produces better returns? With little academic research on the subject, there is no obvious answer. Campbell R. Harvey, Sandy Rattray, Andrew Sinclair, and Otto van Hemert compared hedge fund managers between 1996 and 2014 and found very little difference between the managers’ systematic and discretionary performance, particularly in equities. More recently, in a study of US equity mutual funds spanning 2000-2017, Simona Abis concluded that quant funds outperformed their discretionary peers in non-recessionary periods, but mutual funds outperformed their counterparts how much during recessions.
Both fundamental and quantitative schools have their strengths. The first provides clear explanations, consistency over time and across opportunities, and subjective assessments of complex issues. Meanwhile, the latter takes advantage of the advantages of scale, objectivity and sensitivity analysis. But these two philosophies have natural conflicts. It is difficult to be both objective and subjective, to strive for clear explanations in the presence of complicated equations, and to consistently identify real alpha-generating opportunities rather than data mining artifacts.
However, on a recent call with a head of quant strategy for a large primarily fundamental asset manager, we explored the common ground between quant and fundamental investing, and I came away even more convinced that success in today’s market requires a hybrid approach that leverages the best. of the two worlds
As we explained that at Essentia we use behavioral analytics to help key managers reflect on their own decision making, this head of quant got really excited. “This is the same approach we would take to build a quant strategy,” he said. “We’re looking at the factors that make the difference in performance. But you’re putting it in a language that core administrators will understand and tools they’ll use. That’s going to be intuitive for them. I saw that being very helpful.”
In other words, he identified behavioral analysis as a natural way for fundamental managers to fill a gap in their process by applying quantitative analysis to their own decision-making to test and adjust their existing driven investment models by humans
And if more managers put their own processes under this microscope? After all, we are all aware that quant models melt into the prejudices of their human creators. Also, few quant strategies are fully computer-driven, on a day-to-day basis: human decisions often override or at least update the model at regular intervals. While quants thoroughly test the algorithmic decisions their models make, they tend not to apply the same objective and rigorous analysis to their human decisions.
While fundamental and quant managers may not formally merge their investment approaches anytime soon, both will benefit from recognizing that they increasingly combine human- and machine-led factors, just to different extents. And both will find value in it reflecting on the quality of the decisions that are being generated by the investment processwhether this process is being driven more by humans than by machines.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Clare Flynn Levy
