Reversal of Fortune
IN PRINT ARCHIVE CIR Summer 2008
By Craig Scholl, director, Lazard Asset Management
Many investors were drawn to quantitative investing by the returns. The InterSec International Equity universe of quantitative managers outperformed fundamental managers by a substantial margin in 2003 and 2004, was even in 2005, and outperformed again in 2006. In 2007, however, a new chapter was introduced as quantitative investing underperformed. The magnitude of underperformance was markedly less than the outperformance of 2003 and 2004 but investors were disappointed by what some had thought was a “sure thing”. Also frustrating was the lack of diversification among quantitative managers, particularly in the dramatic underperformance of August 2007.
The 2007 performance reversal was the result of a sudden and dramatic increase in volatility. Volatility, as measured by the Chicago Board of Trade Volatility Index (VIX), had been in a steady decline from January 2003 to February 2007. The VIX then jumped from 10 to 30 in the six months following February and continued to increase during the year. August’s underperformance was liquidity-driven and a consequence of investors reducing risk. The broad impact of these risk trades was short-lived leaving quantitative managers to work within an increasingly volatile market.
Should investors have been surprised by this jump in volatility? Many individuals rely on the recent past to predict the future exemplifying the axiom “the trend is your friend”. However, the economist Hyman Minsky has pointed out that periods of stability may create the conditions for market shocks. For example, the market euphoria for technology and growth in the years prior to 2001 created large valuation spreads. Relative value investors outperformed in the years following 2001 but this performance created increasingly narrow spreads and lower returns. Some value investors compensated by increasing risk. Hindsight clearly shows the damage that chasing returns created. The greatest harm was to those investors who created leveraged exposures to value.
Strategies with diversified approaches to stock selection suffered less as the opportunities to differentiate on growth continued throughout this period. The dispersion of companies by growth has been relatively constant, implying that ongoing opportunities are available through well-designed growth approaches.
Timing exposure between growth and value can be difficult, however research has shown that a core, risk controlled strategy that balances research-based insights between valuation and growth, as well as other measures, is the best path to consistent excess returns. When opportunities diminish in one arena, such as value, a balanced model will still be able to outperform.
Nimble footing needed
There is every indication that investors will continue to be well-served by quantitative investment strategies that are core and risk controlled. What is unlikely to work is a monolithic bet on value, particularly if that bet is leveraged. The current market offers a tremendous opportunity for quantitative managers who are nimble and market-focused.
The diversification advantages that quantitative strategies offer multi-strategy investors are compelling. Quantitative approaches provide clear process and investment thesis differences with fundamental managers without sacrificing expected returns or investment excellence. Modeling companies across the capitalization spectrum and around the globe can identify excellent investment opportunities that are potentially overlooked by fundamental managers. Style diversification continues to be attractive given the investment logic of using style-neutral portfolios to complement style-specific or style-timing strategies.
Many of the excesses that allowed portfolios with leveraged value exposures to excel have been wrung out of the market. Experienced quantitative investors with good judgment and a balanced set of investment models are well-positioned to add value and control risk in this volatile environment. Investors will continue to benefit from the use of portfolios shaped by discipline and positioned for consistent excess returns.