Investing March 13 2023

What is Quantitative Investing and How Does it Work?

We often learn about hedge funds that incorporate a strategy called quantitative investing. These are also called quant funds and were popularized in the last few decades. Believe it or not, this is not a strategy only hedge funds can use but also retail investors. That’s why it’s important to understand it.

So, what is quantitative investing? In brief, it is an investment strategy that aims to exploit market inefficiencies through computer systems by analyzing large sets of data to compute the probability of successful trades.

In this article, we want to give you an overview of the types of quantitative investing and real-world examples of quantitative hedge funds, as well as help you understand if this approach is for you.

Let’s get started…

What is Quantitative Investing and its Types?

Quantitative investors use mathematical and statistical models to track the performance of various assets like stocks, futures, and options and then trade those assets based on their observations in a systematic way.

A quantitative investor could be engaging in statistical arbitrage, high-frequency trading, algorithmic trading, or a variety of these approaches.

Hedge funds are the ones that are mostly associated with quantitative investing because they often trade based on a quantitative strategy. However, mutual funds and even retail traders can now be classified as quantitative investors because the technology required is more accessible these days.

Bear in mind that quantitative investing may be split into different types, but many investors and funds often use a combination of them.

Here are the broad categories of quantitative investing you should know:

  • Arbitrage: This is a strategy that involves simultaneous buying and selling of the same security or correlated ones to profit from the difference in price movements. There are various approaches to applying this strategy, but a very famous one is called merger arbitrage; you buy the shares of a target company and short the ones of the acquirer at the same time.
  • Systematic Macro Trading: In this strategy, you identify market inefficiencies (usually across the globe) and allocate your capital throughout different countries, sectors, and asset classes accordingly.
  • Factor-Based Investing: Basically, you develop a trading algorithm that ranks assets based on their fundamentals or technical indicators with buy and sell rules based on the ranking process. Ranking is based on historical data that the investor thinks are going to be factors for future outperformance. Some examples of that data an investor could be using are value, growth, momentum, and price movement. It’s most common for factor-based investing funds to be using a combination of such data to forecast outperformance.

Real-World Examples of Quantitative Funds

Now, let’s take a look at some good examples of funds that employed a quantitative approach to investing.

Medallion Fund

The Medallion fund by Renaissance Technologies has been the most profitable hedge fund in the world.

Its founder, mathematician James Simons, founded it back in 1982 and for three decades, it has returned more than 66% per year before fees and 39% after fees (source).

Based on Bradford Cornell, a University of California Los Angeles professor emeritus, Medallion could turn $100 into almost $400 million in that time frame.

The strategy of Renaissance Technologies is statistical arbitrage and involves holding thousands of short-term positions at any given time. The fund engages in high-frequency trading but has also held positions for up to a couple of weeks (source).

Quantitative Investment Management (QIM)

Quantitative Investment Management (QIM) is a hedge fund co-founded by Jaffray Piers Woodriff that employs a “Black Box” statistical approach.

Woodriff was listed by Forbes as the most highly compensated hedge fund manager in 2011 (source). His fund didn’t charge any management fees but it had an incentive fee of 30%, based on Jack D. Schwager’s book, Hedge Fund Market Wizards.

Based on that same book, from 2001 to 2011, a proprietary account (no fees) of the fund that was based on one of the futures trading programs realized an average annual compounded return of 118%.

The strategy of the fund involves large-scale data mining and market-neutral positions.

Princeton Newport Partners and Ridgeline Partners

Edward O. Thorp is a hedge fund manager and most famous partly because of writing the book Beat the Dealer, in which he proves that you can gain an edge over the house in blackjack through card counting (back when it was written at least).

He has founded 3 hedge funds and we have information regarding the performance of the first two:

  • Princeton Newport Partners, which he operated from 1969 to 1988. It realized an average annualized compounded gross return of 19.1% before fees and 15.1% after fees. The strategy was market-neutral derivatives hedging.
  • Ridgeline Partners, which he ran from 1994 to 2002 and returned a compound rate of 21% per year with just a 7% annualized volatility. The strategy was statistical arbitrage.

Source: Hedge Fund Market Wizards, Jack D. Schwager.

Does Quantitative Investing Work?

The simple answer here is that quantitative investing works for a minority of investors.

But here’s the more complex one. The only way to measure the performance of quantitative investing is to use hedge funds as a proxy for quantitative investors. This is imperfect, of course, but here it is…

The S&P 500 index has outperformed hedge funds from 2011 to 2020. That’s a decade of underperformance for hedge funds.

But it’s well known that most hedge funds aren’t successful in beating the market and, more importantly, many claim that they don’t try to (their job is to “hedge” a diversified portfolio). Growing assets under management and unusually high management/incentive fees impede outperformance as well.

Additionally, there was, is, and always will be a small portion of hedge funds that outperform the market. The real-world examples above which are just some of the most famous cases can testify to that.

But their outperformance may not be relevant to you if you plan on running your own quantitative investing strategy because of a different size of AUM, different access to market data, and different manpower.

So, the more nuanced answer here is that:

  • Quantitative investing does work for many hedge funds as a way to produce uncorrelated returns or hedge a larger diversified portfolio.
  • There is only a small percentage of hedge funds that outperform the market over long periods, while the industry underperforms on average.
  • The hedge fund industry is an imperfect way to measure the performance of quantitative investing

Is Quantitative Investing for You?

First of all, if you are interested in investing your money in a hedge fund that runs a quantitative strategy, you must know you need to be an accredited investor.

An accredited investor is usually one that has either a high income or a high liquid net worth. If you live in Canada or the United States, that means that:

  • You must have made at least $200,000 in pre-tax profit ($300,000 if you use your combined income with your spouse) in two years in a row and expect to make more in the current year or
  • You have, alone or with a spouse, net liquid assets of $1 million before taxes.

Assuming that you are an accredited investor, here is why you should consider investing with a quant fund:

  • You want to lower the overall volatility of your portfolio by allocating some of your assets to a low-volatility hedge fund.
  • You want to diversify your portfolio by investing a part of your portfolio into a hedge fund that provides uncorrelated returns to the market.
  • You want to attempt to beat the market by investing in a hedge fund that you have good reason to believe can do so for a long time.

If you want to create and operate your own quantitative fund, you must additionally consider the following attributes necessary for success:

  • You’re more of a systematic trader and not a discretionary one
  • You have coding skills or access to related software
  • You are passionate about testing multiple hypotheses and keep evolving your model

How Dangerous is Quantitative Investing?

Quantitative investing can be dangerous for your portfolio, especially if you’re new to this.

Traders engaged in this first create a trading model and backtest it before they apply it. However, backtested performance is not a sure indication of similar future performance.

For this reason, you shouldn’t use all of your wealth to invest in this manner while you learn. Ask yourself what percentage of your liquid assets you would be comfortable losing while you test the waters and don’t invest more than that for some time.

The prudent approach is to create a separate brokerage account just for this endeavor. And because as a quantitative investor, you might want to test multiple models, you will probably need multiple accounts.

This is definitely the right approach but it can become messy. For this reason, also consider creating a free Wealthica account so that you can keep track of all of these accounts in one place.

Wealthica is an asset aggregator that you can use to connect your bank and brokerage accounts. The idea is to always have an understanding of your overall financial situation in order to make more informed decisions.

So before you leave here and get started with quantitative investing, take a moment to sign up for free and take your financial well-being to the next level!