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I’m a quantitative analyst—Trust me, I know what I’m doing.
Judging by the Hedge industry’s advertisements and job listings, until very recently quantitative analysis was the hedge industry’s answer to all of the investors’ needs.For example, I recently heard a marketing manager talking with a potential client.The client said, “But your system is based on statistical analysis and statistics lie.”The marketing manager corrected him, “But our system is NOT based on statistical analysis.It is based on Quantitative Analysis, which doesn’t have the same problems.”
As a quantitative analyst, I suppose, I should pump my fist into the air and shout, “YES!”Unfortunately, the marketing manager wasn’t just wrong, but stupidly wrong and, perhaps, legally liable.
Shifting risk. Not only does quantitative analysis not solve all of an investor’s problems; it isn’t clear that it solves any of an investor’s problems.As a risk management technique, quantitative analysis resembles squeezing a balloon: You can shift risk from one place to another, but you can’t eliminate it.Now, shifting risk from one place to another can be a very good thing to do.But it can also be a waste of time or even dangerous.
Quantitative analysis is, or should be, just another name for certain types of scientific research.For example, if you’re planning to buy gold whenever the price rises above a 20-day moving average, it might be useful to know whether that plan has worked in the past.Notice that some, but not all, of the risks of buying gold are shifted from the individual trades to the research process.Notice also that while the above example resembles what our boys and girls are doing in the trenches, it is misspecified and malformed.
Prudent investing, therefore, demands that fund-of-funds managers somehow judge the quality of a quant’s research before placing money with him.This can’t be done by evaluating the quant’s track record alone and yet this is precisely where most fund-of-funds managers spend most of their time, and some spend all of their time.There is less here than meets the eye.
What information track records contain is partially hidden by the money management techniques the quant employs or does not employ.Besides the track record, fortunately, there are two other sources of information: the quant’s research technique, if any, and his psychology. Lab notes. A quant’s lab notebook reveals his research technique or lack thereof with blinding clarity.A lab notebook is an annotated listing of tests and experiments, including programs and results.A lab notebook is such a powerful tool that a sufficiently skilled fund-of –funds manager can tell certain types of bad work from across the room.
Some of the criteria for evaluating a notebook are fairly obvious.For example, the clarity of the thinking that went into a particular experiment.For example, the degree to which the conclusions are supported by the available evidence.Other criteria are not obvious; knowledge of trading and statistics and programming doesn’t hurt.
The fund-of-funds manager faces two problems here.First, many quants don’t have a lab notebook.In the unlikely event that a quant will admit he doesn’t have a notebook, the fund-of-funds manager can safely ignore his work.
The second and far more frequent problem is that many quants consider their lab notebooks proprietary.I speak from a weak moral position here: I have worked for both fund-of-funds and hedge fund managers.An offer to sign a non-disclosure document might help.A reputation for not talking about past assignments helps too.
With a sufficiently paranoid quant, however, even a nondisclosure document might not help.In which case, the fund-of-funds manager can ask the quant to talk him through his research process.Most quants understand that it’s the fund-of-fund manager’s responsibility to ask such questions and their responsibility to answer them.I’ll discuss this and quant psychology in future columns.
All but the most paranoid quants will answer questions on their programming environment, that is, their software and data sources.This is enough to eliminate some.The fund-of-funds manager needs to know the quant’s approach to the markets and the kinds of problems the software the quant uses can solve, if any.For example, certain very popular brands of technical software can’t handle high frequency finance, trading on a tick by tick basis.A quant claiming to use one of these brands for high frequency finance can be safely ignored.
If the quant doesn’t provide enough information to make a reasonable decision, the fund-of-funds manager should politely thank him for his time and go to the next manager on his list.I have met enough paranoid investment managers to understand that a paranoid is not necessarily a fool or an incompetent.But a fund-of-funds manager who does not make that assumption is not doing his job as a fiduciary.
An earlier version of this article was published in MARHedge.
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"If your mother says she loves you, check it out." --Old reporters' motto; also our motto. Copyright (C) 2005, 2006, 2007, 2008, 2009 Fred Gehm. All rights reserved.