The Quants Are Coming!

By Bob Wood

There is little doubt that in the near future, some of you will hear about the next big thing in managing investment portfolios, and it will sound like something you should be heavily involved in. Let me be the first to throw water on this next great idea before you are convinced to commit your savings to those selling this scheme.

‘Quantitative investing’ is now being touted as the real deal. Few will mention that the general concept is not new. The spin being used to sell investors on the idea involves the use of computers as stock pickers as opposed to humans who have traditionally been charged with the work of active investing and stock selection. Let’s get the first lie out of the way first.

The basic idea is that a computer will choose the best stocks to buy, when to buy them and when to sell them. But who programs the computer on what to choose, and why? Of course, people do that, so there is something fishy about taking human intelligence and decision-making out of the equation. Someone has to program into the computer a criteria for stock selection. And isn’t that humanly subjective? And isn’t it based on what may have worked well in the past, under different economic conditions than what we see now?

What has allegedly been removed is human error, caused by emotion as much as anything. At long last, The Rational Investor has arrived! Instead of a human money manager choosing what to buy and when, a computer will look for predetermined characteristics such as earnings growth, stock price momentum, improving earnings quality, reasonable valuations and so on.

The computer will couple that set of fundamental analysis with technical signals such as a stock price moving above a moving average of some sort and the stock is bought, automatically, or a buy signal is generated that alerts a human that a buy order should be placed. The errors caused by a human being stubbornly committed to a bad stock purchase, or over-ruling his own sell criteria are eliminated.

Now, here’s another problem I see with this approach. Do any of those fundamental criteria mentioned above look like the things that most value-oriented investors are looking for when choosing which stocks to buy? Is there any secret in those valuation metrics being among those considered to be favorable among the legions of active managers?

In the case of the well-known technology names, is there any allowance made for stocks like Yahoo whose management look at the company as their own personal piggy bank, taking millions of shareholder cash with them as compensation in the form of options?

To be fair, the proponents of quantitative investing tout the performance record of this method as being superior. But as with all other investing fads in the past such as The Dogs of The Dow or the Warren Buffett approach to value investing, the more widely accepted those methods became, the less effective they were. Once the crowd catches on, performance dips noticeably.

I mean, buying stocks based on the criteria favored by Buffett became so popular that investors everywhere started looking at the same stock screens and buying those names that seemed to have what the famed value investor looked for in a stock. The rush to buy these value stocks sent the prices of those stocks so high that even Buffett himself wouldn’t buy them since they were no longer properly priced. But that didn’t stop the Buffett adherents from buying them!

Much the same fate affected the aforementioned Dogs of The Dow followers. Once the method of buying the Dow stocks with the highest dividend yield at the start of each year became popular, creative managers looked for ways to game the method, like buying those stocks in December in anticipation of the crowd following in January, or The Motley Fool’s ‘Foolish Four’ variant, which they later abandoned due to performance issues. But of course, both methods succumbed to the usual problem; the crowd was in on the game and affected valuations in ways that those methods didn’t factor in.

Another problem with methods like these are their reliance on the past. The assumption that valuation metrics that proved reliable during different economic times will prove enduringly useful. And as all back testing is susceptible to, what worked in secular bull markets may not work nearly as well during secular bear markets like the one the domestic markets are ensconced in now.

But that doesn’t stop the marketing people on Wall Street. Investing in index funds became popular when people like Jack Bogle and Warren Buffett advocated for them in the late 1990’s. Those riding the S&P 500 index down almost 50% during the 2000-2002 bear cycle might have looked askance at the value of indexing. Suddenly the crowd decided that having an active manager at the helm to keep watch on losing portfolios made sense after all, in spite of what dismal long term performance comparisons had shown.

So hedge funds became the next big thing since they had performed so well during the bear cycle, focusing on absolute returns. Then the crowd followed and over $1 trillion was invested in the 8,000 or so offerings using that method.

The talk today is that low single digit returns in 2006, following returns that failed to beat the general market is souring investors on hedge funds that charge incredibly high fees while performing amidst the pack of more traditional offerings. One fad replaces the next, and the brokers constantly strive to find the next fad, usually by looking at what works before the crowd notices, then selling recent performance as an enduring thing.

You can see for yourselves since there are several mutual funds out there using quantitative methods. The Schwab Core Equity fund, SWANX is one that has been around for long enough to make a judgment on. This large cap blend fund is performing decently enough, but still lost almost 20% during the worst year of the previous bear market cycle in 2002. This fund shares a trait with virtually all traditionally managed mutual funds investing in stocks, that being correlation with the market in general. When the market rises, so does this fund. When the market falls…you get the idea.

Mutual funds from the Numeric Funds group also use the quant method. The N/I Numeric Growth fund, NISGX has been something less than a stellar performer when compared to its proper benchmark with small and mid cap indices hitting new all time highs earlier this year. And the fund’s turnover rate, as quoted by Morningstar at well over 300% annually looks like a red flag of sorts. Why the constant trading while investing in value stocks?

To me, the next new thing is always something that has been around for a while and has recently done well, and can be sold as something different, the natural evolution of the investing science. The brokers are always in need of something to sell, and using esoteric methods like quantitative, computer-generated management seems worth more to the marketers than it is to investors. And like all of those wonderful sounding trading programs that some of you may have bought in the past and used with less than the advertised results had promised, the game continues.

It’s just my guess, but it seems that someone develops a method that beats the market for awhile, until for some reason, it stops working its wonders. So the developer of the method does the only thing he can do to make a profit from the method involved. He sells it to the crowd! Then the crowd piles in, pays too much for those featured stock selections and the method breaks down.

Some time later, the crowd gets disillusioned and moves on, whereby some other promoter resurrects the methods, tweaks it some and explains how those past investors did something wrong and messed the whole thing up. But the new promoter has it all figured out and it’s working again, so pile in!

The cycle repeats until someone else shows the big brokers another hot method, or a better way to sell an old one and the selling continues. To me, trying to find an easy way to beat the market is a fool’s errand. Everything that could have been tried has been by now. Every trading scheme, every valuation combination, every technical system…they’ve all been tried. But how many investors do you know who have beaten the market over time?

There is only one method that works over time, and that is in finding the best long term bull markets available and riding them out, taking several years to do so. There is always a bull market somewhere, in something. But looking for ways to profit while buying stocks in markets that are over-valued like the domestic markets are based on some new whiz-bang method is just the latest iteration of what works well for the sellers, and poorly for the buyers.

I would challenge anyone who touts The Next Big Thing to compare how it would do, or how it has done, against a mid- or small-cap index fund during a bull market. And in bear market cycles, do they perform as advertised, or simply ride the same tide as every other mutual fund?

I prefer to find the best valued markets and ride them until they become expensive, and then go looking for better values elsewhere. It’s always been pretty simple, and Buffett himself adheres to similar thinking. What will work now is what has always worked, and that’s a very simple attention paid to valuations. I don’t see that ever changing.

Have a great week,
Bob

Bob Wood ChFC, CLU Yusuf Kadiwala. Registered Investment Advisors, KMA, Inc., bwood44@tampabay.rr.com.•