Introduction To Quantitative Investing

What if I could introduce you to an investment style for equities that can soundly beat the market over time and only requires a few days a year of work? Interested? I thought so. Today I want to introduce you to Quantitative Investing and why you should consider incorporating it into your investment portfolio.

Quantitative Investing is a fancy term for systematic, structured investing that automates buy and sell decisions. It represents a combination of passive and active investing. Other terms for it are automatic investing or computerized investing. Many investors are familiar with some very infamous stories of quantitative investing gone wrong, the most prominent example being the failure of Long Term Capital Management in the late 90s. And there are a slew of hedge funds the run very complicated ‘quant’ strategies. But quantitative investing can be quite simple as well, and yet very effective. In a way, the S&P500 index is an example of a quantitative strategy. The S&P500 is a large cap strategy where the buy and sell decisions are decided for the investor. The active part here is the specific choice of large cap stocks. Companies are added and deleted every so often by the S&P committee thereby automating buy and sell decisions. Personal and emotional decisions don’t come into play at all. This simple quant strategy has outperformed over 70% of mutual funds over time. It never panics, has second thoughts, or varies from its core strategy. And there in lies much of its strength and why indexing outperforms most active managers over time.

But there are other simple quantitative strategies that outperform the S&P500. One famous example is the “Dogs of the Dow” strategy. This is a strategy that buys an equal amount of the 10 highest yielding DOW stocks every year. Pretty simple. From 1928 through 2009 this strategy returned 11.22% per year vs 9.12% for the S&P500. There are many other examples of outperforming strategies that take advantage of time tested factors that consistently beat the market over the long term. I’ve discussed the 3 key factors in outperformance before, they are value, small capitalization, and momentum. I’ve also discussed one way to take advantage of these factors, by indexing to them through ETFs. This is yet another example of a quant strategy. Now comes they real exciting part. You can do even better than just indexing to these outperformance factors through ETFs. The first thing to do is to find out which are the best quantitative strategies. Fortunately there is a great resource, the bible of quantitative investing so to speak, the book What Works On Wall Street by James P. O’Shaughnessy first published in 1996 and now in its fourth edition, published in 2011. This book goes through hundreds of quantitative strategies and ranks their historical performance, risk, and many other parameters. As a teaser, in the table below I excerpted the top performing (ranked by sharpe ratio – risk adjusted return) strategies from the book with a comparison to the S&P500. Don’t worry about the strategy descriptions, they are well described in the book.