A Dynamic Future for Active Quant Investing

I recently put the following article written with my friend Rodney Sullivan on SSRN (I mentioned this effort in an earlier blog).  Without great surprise, this article should appear in Journal of Portfolio Management next year. 

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1679766

It is about our view on the future of active quant investing.  The current active quant investing model is fatally flawed, just like Euro being a flawed currency.  Take this analogy further, Euro may yet survive the current crisis, because it is more of a political tool to integrate Europe than a product due to economic rationale.  Without a unified fiscal authority, breaking down of cultural and language barriers to allow real free labor movements, it is a doomed currency, with the only uncertainty about its collapse being the timing.

The current active quant investing is similarly flawed.  They are mostly riding on some long-term trends unintentionally (e.g., small, value, and momentum).  If you take these long term trends away, they got little game going.  This means that some smart semi-active ETFs can easily replace them, with the same boom and bust cycle of performance.  This also means that clients should not have paid them that much for doing what they are doing today.

When they are against the trends, they have no clue what to do.  Even more strange is that in the last few years, I talked to quite a few quant firms and mentioned that they should incorporate some quantitative but not systematic analysis to turn around their performance.  Even though some of them made good offers to me, none of them is flexible about their investment approach.  I ended up not taking any of those offers because I thought they are doomed, at least in the long-term. 

Some of them did start to go down the direction that we discussed in the article.  Some of them are looking more into the macro level and try to incorporate more information there.  Even there, the only approach is systematic and pure quant, which essentially doomed the effectiveness of the macro push.

The above article provides a decent, yet somewhat incoherent, guide about how quants should change to make their long term business model viable.  Rodney was instrumental in moderating the tone of the article, but we still get some hate mails, and we understand there could be many more hatred out there.  I am good at making the piece more coherent, but I sometimes cannot hold my punches.  So the current state of the article may be the best constrained optimum, given the hate mails we have already got. In the next revision, we will try to make it more coherent yet still moderate enough, and also incorporate any comments we get.

What surprises me is how close minded many of the quants are.  Even if the article is completely garbage, there is no need to hate, especially given the sorry state of quants in the last few years (which I correctly predicted in early 2008).  At least be open minded and see if there is anything useful there.  I would do that myself.  Further, I am surprised that no one was flexible enough to at least allow me to have an alternative investment approach under their roof in the last couple of years.  Maybe the only alternative is to have a start up to run an independent show, even though that takes a lot of time and preparations.