Quantitative Investing & the Marketplace
The past 30 years have seen a profound transformation in the world's financial
markets fueled by the globalization of markets and the dramatic advances in
computer and telecommunication technology. As a result, there has been a proliferation
in the types and complexity of securities; witness the explosive growth in
the derivative and asset-backed securities markets. Among the other features
of the changing nature of the financial landscape is the flood of new money
into the securities markets as a result of the growth in pension funds, 401(K)s,
IRA's etc. and the movement of control of investment funds from the individual
to the institutional money manager.
Paralleling the remarkable transformation of the financial markets has been
the development of what is called by some the "new science of finance," an
evolving interdisciplinary approach combining financial research, statistics
and other mathematical disciplines, physics, computer science, biology, behavioral
and cognitive science.
Some of the early quantitative methods included the successful identification
by Yale mathematics professor Benoit Mandelbrot of patterns in cotton prices
in the 1960s. From this and subsequent investigations, Mandelbrot developed
the theory of fractals, which applies to such divergent phenomena as turbulence
in liquids, the structure of plants, and the behavior of markets.
By the 1980s, there was mounting evidence that predictive systems could be
built and successfully deployed:
These and other developments increased the interest in quantitative methods.
Today, predictive financial models are being developed using a variety of techniques,
including fuzzy logic, neural nets, genetic algorithms, Markov models, fractal
methods, and clustering techniques. Neural nets have been used by Citibank,
Credit Suisse, Advanced Investment Technology (owned by State Street Global
Advisors), Nikko Securities, Normura Securities, Morgan Stanley, Bear Stearns,
Shearson Lehman Hutton, and Fidelity Management & Research.
- Work by Mandelbrot and others demonstrated fractal patterns in financial
markets. Patterns were found and exploited governing the volatility of foreign
exchange markets. It was found, for example, that volatility was dependent
in part on who was participating in the market at a given time. For instance,
volatility dropped during the time that Asian traders went to lunch and
increased when New York and London were both trading.
- Robert Engle found that volatility was not random but that periods of
high and low volatility last longer than the traditional random models had
predicted. Engle discovered "clustered" models of volatility that had predictive
- In a 1990 study, Andrew Lo and C.A. Mackinlay found that a positive return
in weekly stock indices were positively correlated with positive returns
during the following week.
- In a 1991 study by the Santa Fe Institute, which put popular technical
analysis techniques to a rigorous test using 90 years of data from the Dow
Jones Index, it was found that both the moving average rule and trading-range
break rule worked quite well.
First Quadrant, which manages over 27 billion dollars in assets (including
$2.2 billion in long-term strategies), is using genetic algorithms for research
purposes in a variety of their financial services. The Renaissance Technologies
hedge fund, run by mathematician James Simons, although a relatively small
fund (about $2 billion), has reported a 20% annual return for the past ten
years using all quant methods. Another fund run by the "Prediction Company,"
which uses nonlinear time series methods developed by former physicists from
Los Alamos, has also had very positive results.
The biggest contemporary impact of quant methods is as a tool used in combination
with human decision making. The International Association of Financial Engineers,
the leading professional association for the growing field of financial engineering,
conducted a study of the usage of quantitative techniques in financial firms.
The survey was sent to 200 of the largest investment banks, broker/dealers,
insurance companies, and other financial institutions around the world. The
focus of the study was the importance of the role of quantitative techniques
and the use of mathematics talent in implementing financial management techniques.
Of the 50 respondents, 40% reported a heavy dependence on quantitative methods
and 75% cited a moderate or higher dependence. 76% of the respondents noted
that the proportion of quantitative professionals in their firm has increased
over the past 15 years with 71% expecting that the proportion will continue
to increase. Another indication of the increasing excitement and potential
surrounding quantitative methods is that a large proportion of the doctorate
graduates in theoretical physics from universities like Harvard and Stanford
are going into financial research.
There are a number of trends indicating that quantitative methods will be
of enormous importance in the years ahead:
- The rapidly increasing availability of online financial information,
which is necessary to train self-organizing methods such as genetic algorithms
and neural nets, is growing very rapidly.
- Patterns in financial trading data representing arbitrage opportunities
are often too subtle for human analysts to detect, but very powerful statistical
techniques (combined with application of significant computer processing)
can detect these patterns and develop strategies for exploiting them.
- Computational power is growing exponentially, which is another important
ingredient for complexity theory methods. There is also growing availability
of dedicated parallel devices for neural net connection calculations and
- Advances in quantitative techniques are leveraged by the enormous size
of the market, now estimated at over $20 trillion. According to Thomson
Financial, of the $20.9 trillion of total market capitalization in 1997,
$12 trillion was controlled by institutional money managers, and, in a recent
publication, Instinet Corporation (a subsidiary of Reuters Group PLC) states
that the value of all holdings in the U.S. "increased from $849.9 billion
in 1969 to $14.6 trillion in 1998."
- The four largest U.S. institutional investors: Fidelity ($695 billion
under management), Barclays ($615 billion under management), Merrill Lynch
($501 billion under management) and State Street ($490 billion under management)
account for $2.3 trillion or over 15% of total securities in the U.S. These
firms are in highly competitive environments; their clients are able to
track their performance and move their funds readily to the best performers.
Being able to gain even a slight advantage by obtaining superior technology
when leveraged by the large sums under management would have very significant
value. Fidelity, in its own description of itself, states that, "this year
alone, Fidelity will invest $500 million dollars in hardware, software,
and systems that enable us not only to analyze and research virtually all
the world's markets, but to provide customers with the most up-to-the-minute
information they need to help them make sound financial decisions." As huge
amounts of investment are at stake, we believe that these firms are prepared
to move quickly to maintain and increase market share.
Examples of quant funds include the following: In 1997, D.E. Shaw & Co.,
using quantitative methods, accounted for up to 5% of the trading on the NYSE;
as of mid-1998, the quant firm BNP/Cooper Neff Advisors accounts for 4 to
6 percent of the total on the NYSE and 6 to 10 percent of the volume of a
number of European exchanges volume; First Quant's managed assets grew from
$11 billion in 1997 to $27 billion in the final quarter of 1998; and, according
to Andrew W. Lo "as much as 20% of hedge funds, which control some $295 billion,
are quantitatively oriented."
Quant funds are making significant inroads into the institutional investor
community. In a 1998 Wall Street Research report, Ashton Technology Group,
Inc. states that quant funds (along with index funds) represent the fastest
growing institutional investor groups. Industry observers estimate that quant
funds control approximately 5% of the $20 trillion in the market, and are
growing rapidly. Goldman Sachs was reported to have purchased a quant technology
company for $600 million.