Is quantitative investment necessarily a « black box »?
Analysis by Charles Lacroix, CEO of Chahine Capital for H24 Finance.
Despite a history spanning several decades and a significant place in the portfolios of Anglo-Saxon institutional and retail investors, quantitative investment is still relatively marginal in the allocations of their European counterparts, even though it has been gaining ground in recent years.
Indeed, quantitative investment, with its systematic, disciplined approach based on pre-defined investment rules and limits, and its ability to exploit vast quantities of data, seems increasingly well suited to a world where, for many players, too much information now kills information…
And yet, when the teams at Chahine Capital, who have been implementing a systematic “Momentum” equity strategy for over 25 years, talk to investors, we often hear the term “black box” thrown around.
How can we explain this discrepancy between some investor’s perception of quantitative investment and what it actually is?
There are several possible explanations:
1) A multi-factorial approach sometimes difficult to grasp for the non-specialist
The added value of quantitative investing lies in the identification and exploitation of proven factors or risk premia whose persistence has been demonstrated both academically and empirically (“Growth”, “Value”, “Momentum”, “Quality”, “Low Volatility”, “Carry”, to name but a few).
To improve the robustness of their strategy, and given that no single factor works all the time, however attractive it may be over the long term (think of the “Value” factor between 2007 and 2021, i.e. for almost 14 years!), many quant investment managers will tend to diversify the risk of their overall portfolio by aggregating different factors or risk premia.
The disadvantage for the non-specialist investor is that, while he or she may be able to understand how each of these factors works in isolation, it will be very difficult to grasp their interactions and, above all, to anticipate how a multi-factor portfolio will behave in a given market scenario.
One of the strengths of the Momentum factor, which consists in identifying and exploiting the persistence of upward trends in certain stocks, is its adaptability to different market regimes: it simply goes where the market goes, without any structural sector or style bias. As such, it is probably one of the only factors that can be efficiently implemented on its own, making it easy to understand, even for investors who are not specialists in quantitative matters.
2) More or less intuitive factors
While some factors, such as Momentum, are highly intuitive, for the reasons outlined above, others, such as Low Volatility or certain risk premia, such as Carry trade, can be more difficult to pin down.
The determinants of a Momentum strategy’s performance potential are easy to grasp: a visible environment will favor the emergence of trends, while repeated geopolitical shocks or emergency interventions by Central Banks will probably cause the market to temporarily forget fundamentals, or lead to damaging sector rotations.
Conversely, the sudden increase in volatility on a currency pair (e.g. Yen-GBP), which is costly for a FX carry strategy, may have escaped the investor’s notice if his eyes are not permanently riveted to his Bloomberg© screen, making it more difficult for him to judge its suitability for a given market scenario.
3) A varying degree of transparency
While the disciplined and rigorous application of clear, pre-established rules greatly facilitates the transparency that most investors demand, and objectifies investment decisions to a greater extent than discretionary investment managers can, it must be admitted that some systematic managers are reluctant to go into detail about the strategies they implement, or to disclose their portfolios at regular intervals.
There’s probably a touch of paranoia behind this reflex: “If I say too much, some competitors might be tempted to copy me, and I risk losing my competitive edge”. Nevertheless, the indispensable and costly human resources, in the form of highly specialized researchers, and material resources, in the form of investment in data and IT tools, create strong barriers to entry, leading us to believe that this “risk” is greatly overestimated by the quantitative investment industry.
On the contrary, many systematic managers, among which Chahine Capital, have chosen to draw on their expertise in analysis and information retrieval to offer greater transparency on their strategies, ongoing research and results, in order to eliminate any surprise effect for their investors. This makes it much easier for investors to report the results of systematic strategies to their end-clients.
4) “White-box” quantitative investment
In conclusion, the prejudice against “black box” quantitative investment seems to us to be mostly unjustified. Provided that it is implemented using readable, intuitive factors, and that systematic investment managers are sufficiently didactic and comply with the now indispensable exercise of transparency, it seems to us to be the best illustration of Nicolas Boileau’s famous maxim (1636-1711): “What is well conceived is clearly stated, and the words to say it come easily”. In short, the very definition of “white box” investment…
