A CEO’s Guide to Quants (By Dennis Aust, Ativo Capital Management)
As quantitative investment strategies become ubiquitous, it behooves corporate executives in the C-Suite to understand exactly how this can influence the enterprise value of their companies
It’s been estimated that roughly one third of the total U.S. equity assets under management are being deployed through quantitative strategies. As one might imagine, any pool of investment capital this large can have a substantial influence on equity prices and trading patterns. Yet the rise of quantitative investing is largely an afterthought among corporate executives, as most in the C-Suite have only a vague understanding of how quant investors really work and, more importantly, what it means to their companies.
Make no mistake, quant investing has been embraced by a significant and growing portion of global asset managers. While many assume it’s the passively managed exchange traded funds or ETFs that dominate the quant landscape, actively managed hedge funds, mutual funds and separately managed accounts can be just as reliant on quantitative screens and filters in their pursuit of alpha. And quantitative investing is only going to become more pervasive as data volumes grow and as computing capacity becomes more accessible and affordable. Quant strategies will also continue to evolve, particularly as asset managers tap into the power of big data and delve into unstructured or alternative data sets that can go far beyond what’s available through filings or historic equity prices. Moreover, the relentless pressure to lower investing costs will continue to drive demand – thanks in large part to structural changes, such as the shift from defined benefit to defined contribution pensions. And this trend will only become more acute as asset managers employing quantitative strategies establish track records of long-term outperformance.
For these reasons and many others, public company CEOs and CFOs should be well versed in not only how quantitative strategies can influence the value of their share price, but also how their reporting practices and corporate initiatives are viewed when seen through the lens of a systematic factor-based model.
What, exactly, is a quant?
By one definition, a quant is simply an investor who relies on a systematic mathematical model to make portfolio decisions. Such a definition certainly describes the high-powered ‘rocket scientists’ that typify the quant community, but this characterization could also describe the more passive ‘Dogs of the Dow’ investor who adjusts his or her portfolio once a year in pursuit of the highest dividend yield. By that standard, anyone who relies on a calculator for investing could potentially be considered a quant.
A more precise and restrictive approach would qualify quant investing as incorporating data management capabilities and software to efficiently break down and analyze data to identify comprehensive and accurate prediction models and apply those models to investment decision. Even this more specific definition encompasses a variety of investment frameworks, including long/short equity, trend or momentum strategies, systematic arbitrage that exploits stock, sector or asset-class correlations, active or fundamental indexing, and many traditional long-only equity strategies.
Further complicating the definition is the fact that the boundaries can be fuzzy. Many quant investors incorporate some degree of human judgment into the investment process, even if it’s only a final “quality control” oversight step. And some managers that might otherwise rely on traditional fundamental analysis will incorporate quant methodologies to screen stocks for further analysis or rank and prioritize “buy” candidates. A wide variety of managers will also use quant tools to measure and manage risk when determining target weights for portfolio holdings. Pick up any investment publication today and it’s likely there will be a story on the rise of Smart Beta, Active Indexing, or similar strategies that represent yet another application of quantitative methodologies.
Although there may be no such thing as a “typical” quant investor, most will share similar characteristics, such as predominant focus on numbers, be it financials or pricing trends, and generally a minimal interest on qualitative factors, including corporate strategies or management presentations. Most quants will also operate from an expansive universe of potential investment candidates and often demonstrate higher turnover than other types of managers. Moreover, while strategies can differ substantially, it’s often the case that analytical emphasis is trained on preferred characteristics of companies versus the company-specific developments. Company size, profitability, price-to-earnings multiples, and momentum, for instance, may be prioritized in many factor-driven quant strategies that are designed to parse similarities between broad groups of securities. And while much of this may seem new as computing power and commercially available software have led to the widespread adoption of factor-based models for portfolio optimization and risk management, this approach actually goes all the way back to the Arbitrage Pricing Theory (APT), originally proposed by Stephen Ross in 1976.
What is important to quants?
Such complexities may fall into the “nice to know” category, but a corporate executive should still understand how quant investors can influence the stock price of their company. To do so, however, executives must appreciate what’s important to their quant-oriented shareholders in addition to what factors aren’t as vital.
First, as we alluded to, most quants are not interested in press releases, investor presentations, earnings calls, analyst reports or even CEO interviews. In fact, most would just as soon skip the pomp and circumstance that goes with an Investor Day for the comfort and security of their desk and a Bloomberg terminal. Of course, detailed information such as earnings forecasts often do factor into quant decisions, but this information is typically obtained from third-party suppliers. Published news reports can also be important, particularly for those quants that incorporate a human element into their model-driven “buy” and “sell” evaluations. And as quants delve into unstructured data, we’re also seeing new approaches to stock screening, such as digital analysis of the written and spoken word, in which investors are converting press reports, conference calls, and even social media into new metrics that inform and trigger investment decisions.
Second, quants are less likely to care who you are, instead focusing on what you are. This is particularly true for the substantial number of quant investors who rely heavily on factor models. Factor-based buying and selling can often explain market patterns that otherwise appear irrational. In fact, there is for the idea that discount rate variation (another way of expressing factor variation) is even more important than financial performance for understanding stock prices.
Lastly, quants do care about financial performance, even if they‘re not particularly interested in the story behind the numbers – apologies to those in Investor Relations skilled at articulating a narrative that justifies performance. Just be aware that quants are probably looking at company performance in conjunction with other variables, such as stock price, earnings forecasts or assets. Record earnings, for instance, won’t translate into a “buy” decision if the resulting ratios are statistically unfavorable when compared with similar companies.
With all of this is mind, we’ve highlighted five implications for corporate executives of publicly owned companies.
- Recognize that many quant portfolio decisions are beyond your control, including the consequent impact of these decisions on your stock price. However, keeping track of trends can help you explain their impact. Quants buy and sell companies as commodities, representing an imperative to rebalance whenever the numbers change. It doesn’t matter whether the changes are in your reported results or in other market data. We’ve even seen some quant models incorporating research from satellite images that provide data into parking lot capacity among retailers. There’s not much a CEO can do about such moves, but executives and finance teams can monitor publications from quant-risk model providers like Axioma or Barra. If they are reporting that high-volatility stocks got hammered based on quantitative factors, it can provide a ready explanation for board members and other investors. Importantly, this context can provide a plausible expectation that such a trend will eventually reverse course.
- Make sure your reported financial data is clear, accurate and properly reported by the data services. Accurate GAAP or IFRS financials is just the beginning. Clarity of financial reporting is also critical. Once they’ve set their models, quants usually try to apply the formulas to as broad of an investment universe as possible. This breadth, however, comes at a cost. Specifically, as most quants don’t spend much effort understanding individual business strategies, if a company’s financials contain odd or complex results that serve to disrupt or “break” the algorithm, it’s likely that the company’s stock will be dropped from the candidate list. This tendency, unfortunately, occurs regardless of the business logic that underlies any customized or unconventional reporting. It also behooves executives to monitor what the data services are reporting, as these services report on thousands of companies and maintain standard procedures for capturing financial data. Most of the time their rules and judgments make sense, but they can be wrong; it’s better to catch such errors early, before the quants change their “buy” orders to “sells.”
- Financial performance still counts. Even though quants place high importance on company characteristics, this is usually in tandem with one or more performance metrics. Factor models, which rely on statistical correlations between stock price and company characteristics, also include an alpha term, which represents company-specific value creation alongside other systematic factors. Indeed, capturing alpha is a major objective for most quants, so investments that can reliably deliver alpha are in high demand. For instance, a publisher may show consistent earnings growth from its digital assets, and with an improved ROI picture as the company grows beyond its historic business model, in this case print. The company’s shares, in turn, may demand a higher price-to-earnings ratio as the business evolves. If there is a takeaway, it’s that boards should seek to deploy capital carefully as many quants employ fundamental screens for returns on invested capital, and also factor in balance sheets and cash flow.
- Stay on top of evolving trends. Like every other sector, the investment industry continues to evolve, with new concepts first attracting pioneers, then winning broad acceptance. At the moment, for instance, ESG (Environmental, Social, Governance) screens are gaining a substantial following. Besides incorporating ESG considerations in company strategies, executives will want to ensure they are reporting their progress in these areas. In fact, at this early point, many ESG screens are focused on what a company is and isn’t disclosing, and transparency alone can show up favorably through these filters. Transparency is also critical in reporting segment or geographic earnings and revenue. Quants do not just care about the domiciled location of a company; they are increasing looking at direct or indirect exposures to different sectors or countries that may exist.
- Take your stock price with a grain of salt. Most executives understand that the daily fluctuations of share prices can be a terrible gauge in tracking company performance; it’s akin to trying to tell the time with the second hand of a watch. With that said, having a comprehensive understanding of how quantitative investing can impact a company and its shares can be a critical component in evaluating key decisions. Take executive compensation: while many investors may espouse packages tied to share price growth, reaching these incentives may often come down to chance, no different than buying a lottery ticket. It can also add critical context in how companies deploy capital – be it capital investments, dividends or share buybacks.
As quant investing becomes ubiquitous in investment circles, public company executives will need to have at least an appreciation for the impact it can have on share prices. It’s not unlike the challenge facing marketing professionals, who need to establish an understanding of search-engine optimization in order to successfully market products and services in the digital age. At the very least, understanding how quants work will save executives from fretting about why their shares are falling on otherwise positive news.
Dennis Aust is director of research and deputy chief investment officer at Ativo Capital Management LLC
Arth Veda's Gupta expects the ETF market to return to a fundementals-oriented value investment in 2016.