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Your Guide to the Many Flavors of Quant Investing

(Bloomberg) -- Quantitative finance has become a buzzword of modern investing, though it’s been around for decades. Thanks in no small part to the success and allure of firms like Renaissance Technologies LLC, quant hedge fund assets have more than doubled over the past eight years, growing to $967 billion by June 2018, according to Hedge Fund Research. All quant strategies use technology and formulas to automate the investment process, rather than rely on an investor’s savvy or a trader’s skills. The resemblance ends there. Some strategies look for a tiny edge that can be exploited in a day; others scour global trends for investments that last for years. Here’s a sampling, from most to least patient.

Factor investing

You like Indian food and Thai food, so maybe you like all spicy foods.
  • HOW IT’S DONE: Factor refers to a characteristic of an asset -- a stock’s volatility, a company’s profitability -- that, according to the quant’s data, is shared by successful investments. The quant builds a fund that automatically buys assets (stocks, typically) exhibiting that trait. Sometimes known, imprecisely, as smart beta or risk premia.
  • TYPICAL HOLDING PERIOD: Months to years.
  • EXAMPLE: You view value -- is the share price relatively cheap? -- as an historically accurate signal that a stock is going to outperform. Buy the cheapest stocks and short the most expensive ones, no matter their names or type of business.
  • WHY IT MAKES MONEY: It takes advantage of behavioral biases and mistakes that investors reliably make. For example, people tend to undervalue less-glamorous stocks. Factors are also sources of risk that reward investors with superior returns over time.
  • FIRMS THAT USE IT: AQR Capital Management, BlackRock Inc., Goldman Sachs Asset Management

Risk parity

Diversifying, with a twist.
  • HOW IT’S DONE: A type of asset-allocation strategy that aims to hold an equal amount of risk among investment classes, which react differently to market changes. The trader diversifies -- among, say, fixed income, equities and inflation-risk assets -- based not on price but on volatility or some other measure of risk. The less volatile an asset, the bigger weighting it gets in the portfolio.
  • TYPICAL HOLDING PERIOD: Months to years.
  • EXAMPLE: Calculate volatility for four different asset classes. Invest your money proportionally, depending on each’s volatility over the past year. If the result is a bond-heavy portfolio with too little upside, use borrowed money to make bigger bets. At the end of each month, calculate the volatility again, and rebalance.
  • WHY IT WORKS: This risk-mitigating strategy aims to produce a smoother ride, with diversification helping the fund during difficult market stretches.
  • FIRMS THAT USE IT: Bridgewater Associates, AQR, Man AHL

Systematic global macro

See the forest, not just the trees.
  • HOW IT’S DONE: Broader and somewhat more patient than CTA, this approach trades across asset classes and countries and relies upon macroeconomic principles. Using data such as inflation, unemployment and consumer spending, the strategy attempts to build a set of rules that govern the relationship between economic cycles and market movements.
  • TYPICAL HOLDING PERIOD: A month or longer.
  • EXAMPLE: To capture the spread between different currency rates, sell low-interest-rate currencies and buy higher-interest-rate assets. This is called a carry trade.
  • WHY IT WORKS: It benefits from diversification across asset classes. It’s often billed as a risk-mitigating strategy, participating on the upside but protected on the downside.
  • FIRMS THAT USE IT: QS Investors, Quest Partners LLC, Winton Capital Management

Event-driven arbitrage

You don’t need a crystal ball to know what’s coming.
  • HOW IT’S DONE: A classic hedge fund strategy, anticipating corporate actions and events, with an algorithmic approach. It exploits mispricings that occur before or after analyst revisions, share buybacks, bankruptcies and the like.
  • TYPICAL HOLDING PERIOD: Days to weeks.
  • EXAMPLE: A stock’s trading volume tends to rise, as does the price, around its earnings announcement date, when traders are more sensitive to company news. So buy before earnings announcements.
  • WHY IT WORKS: It gets ahead of where the market predictably moves in response to an event.
  • FIRMS THAT USE IT: AQR, BlackRock

Statistical arbitrage

With time, everything gets back to normal.
  • HOW IT’S DONE: Seeks mispricings in the market by identifying relationships among securities, detecting anomalies, then betting on things returning to normal. Shorthanded as "stat-arb" and often used as a catch-all for fast quant strategies. Pairs trading is one well-known version.
  • TYPICAL HOLDING PERIOD: A day to a few weeks.
  • EXAMPLE: Assume Coca-Cola Co. and PepsiCo Inc. will trade similarly. Notice when Coke rises while Pepsi falls. Short Coke, buy Pepsi, profit as they realign.
  • WHY IT WORKS: The strategy takes advantage of the idea that the market overreacts, then adjusts.
  • FIRMS THAT USE IT: Renaissance Technologies, Two Sigma, WorldQuant

CTA

There’s always room on the bandwagon.
  • HOW IT’S DONE: This acronym for Commodity Trading Advisor -- a regulatory label for firms that may trade futures or options -- has become synonymous with systematic, trend-following quant strategies. The trader takes a position -- in equity index futures, fixed-income futures, currency futures and/or commodity futures, domestic or foreign -- only after a trend appears in the price data.
  • TYPICAL HOLDING PERIOD: A day to a few weeks.
  • EXAMPLE: If the energy futures contract you hold closes at a 50-day high, buy energy futures at tomorrow’s open. If it closes at a 50-day low, short them. This is called a channel breakout model.
  • WHY IT WORKS: Asset movements tend to last a least a little while, so investors can make money riding a wave. CTAs are among the most volatile strategies, with only one-third to one-half of trades being profitable. But the profitable ones make lots of money.
  • FIRMS THAT USE IT: Man AHL, Winton Capital Management

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