12 Sep, 2019

Ben Graham was a Quant or Systematic Rule Based Investing

What is Quantitative Investing ?
Quantitative investing attempts to reduce the investment process to its scientific and statistical core, eliminating emotional, human judgment from the equation as much as possible. This quantitative investment process is also known as systems based investing or rules based investing because the investment philosophy is not based on gut feel or discretion. It is based on data and statistics. Also the execution does not rely on human judgement and is rules based.

Ben Graham used fundamental metrics to select securities and his method was actually something that could be distilled down to rules. An interesting read on this is this book called Ben Graham was a Quant. Even Joel Greenblatt’s cheesy sounding book, The Little Book That Still Beats the Market is actually about a rules and systems driven value investing strategy. He cheekily called his method, the “Magic Formula” and clarified that there was nothing magic about it. In a recent paper called “Buffet’s Alpha“, researchers at AQR have analyszed Warren Buffet’s returns over the years and found that “Buffett’s returns appear to be neither luck nor magic, but, rather, reward for leveraging cheap, safe, quality stocks.” Which is exactly what Buffett did. He bought quality and less volatile or safe stocks and then he levered up his portfolio about 1.7x with insurance float and that explained his out performance. What matters however, is that Graham and Buffett figured out these insights far before any one else and stuck to them for years. And that matters a lot. There are many ways of implementing systems based investing, and we are going to use factors or what are popularly called “smart beta” now to implement our system.

What and Why are we doing this now?

Markets are flat to down over the last 12-18 months. Its been pretty brutal in the mid and small cap space especially. We have fortunately been selling or sitting on cash over this period. But this was not all luck. We had a conceptual framework and a system and rules in place to guide us in good times and bad. This came after years of research and knowing what to drop and what to keep. More dropping than keeping.

We thought it would be a good time to take a strategy and offer a peek under the hood and see what it takes to run a systems based investing strategy. So we have decided to take a simple system and to start a live experiment to explain conceptually how one can invest based on a set of rules without any story, narrative and still do as well or better than most investors, may be the index and with lower draw down.

My personal bias as an investor who has lived through dot com and GFC is a strong focus on downside protection even if it means giving up some points in upside returns. The best strategy is not the one that gives the highest returns, but that to which you can stick to and implement in the toughest of times. When everything around is falling apart, there is gloom and doom and it seems like this will never pass. Let me tell you, it always does. Maybe not as quickly as it has in the past ten years though.

We have had several corrections globally and domestically in the last ten years, but this is the longest ( we are about 18 months into it now). We have seen previous bear markets in terms of price and time correction of years in the 90s, post the Harshad Mehta scam and post the dot com bubble. US markets which have a much longer history, have seen several such periods most notably being the crash of 1987, Oil Crisis-Kuwait War in early 90s, and then the other two being the dot com collapse in 1999-2000 and the GFC in 2008.

How have long term investors – whether discretionary, systematic, hybrid, or any other type, stuck to their intellectual moorings over the decades? What was noise and what was signal? How did they live through the years when nothing seemed to be going right. And through those times when everything was too much cheery and over optimistic. Does one have to be a monk and live in cave to tune out the noise ? No easy answer to any of these questions. But we will try and address some of those in our year by year analysis.

Its simple but not easy

Odysseus was the ultimate systems investor. He was warned by Circe that on the way back to Ithaca, he would encounter the sirens. They were known to lure sailors with their melodious singing and cause ships to crash on the rocks close to the shore.

Now Odysseus wanted to hear the sirens, but he didn’t want to get lured by them and cause his ship to crash. So devised a plan. He told his crew, to tie him to a post and ordered them to close their ears with beeswax. And he said under no condition were they to untie him, however much he begged and pleaded. This is beautifully captured in the painting above by John William Waterhouse.

A few days ago, Cliff Asness said in an interview “A huge part of our job is building a great investment process that will make money over the long term, but a fair amount of our job is sticking to it like grim death during the tougher times.”

So what does Odysseus have in common with Cliff Asness. They both know that they have to tie themselves to the post (in case of Asness it is his rules based investment process). As seductive as the siren’s singing may sound and however tempted Asness may be to over ride his investment process, because of the current narrative in the market and media, he knows that in order to survive and get through the journey, he will have to not untie him self from the proverbial post. Asness knows a bit or two about that.

Factor based investing

The CAPM model has long being used by managers to calculate expected returns and then calculate excess returns which are not explained by market beta. However, over a period of time, other replicable factors which have survived the test of academia, time and which have reasonably good risk based and behavioral based explanations for their existence have emerged. These are called factors or “smart beta”. And this has dramatically reduced the edge that “active managers” claimed to have. The most robust among them all, momentum – has grudgingly been accepted as a anomaly by Fama, because in their world this factor should not exist. But as he told Asness years ago, “If its in the data then write it”. So it shows he has the intellectual honesty and integrity and flexibility to a large extent.

Momentum is often confused with growth. But it is not so. Because on their way to mean reversion, value stocks display characteristics of momentum stocks. And over a extended period of performance, they cross over to display characteristics of growth stocks. In Quantitative Momentum, Gray and Vogel bring out this distinction pretty well. They find a significant overlap in value and momentum and growth and momentum portfolios.
The table below shows momentum to be the most robust of factors but they all have seasons so a multifactor model/portfolio is practical and preferred.

Another significant anomaly that we are fond of is low volatility. It has almost reached the status of a factor but not fully yet. We have written about low volatility and here is a blog by S&P on how low volatility has worked as a factor for almost four decades now. So its not a recent post GFC phenomenon.

Systems don’t work all the time

In the years 1998-2000 and in 2007-2008, quants (system driven investors) were face with one of the toughest times in history. Their systems were not working the way they were supposed to work. AQR started in 1998 and was hammered down 35%  in the next 20 months. Value at that time was the worst possible strategy in the world. Sounds familiar. Yeah. Its happening now too. And in particular to the value factor. Back in 2000, Asness responded by writing a paper -“Bubble Logic: Or, How to Learn to Stop Worrying and Love the Bull“. This was his protest against the insanity of prices ascribed to dot-com stocks. Btw this was also a period in which Buffett was told that he has lost his touch. He under performed his benchmark during that period and even now over the last ten years he has under performed the S&P 500 by 1.5% p.a. But his size is much larger now than it was in 2000. And that is also quite a drag. Both Buffett and AQR bounced back in the next 3 years with even more force as the value factor started working and valuations mean reverted.

The next big test for quants came in 2007-08. Before the GFC crisis hit the world in 2008, quants had already faced a quant quake in August 2007. A large amount of liquidation by a big wall street firm (rumored to be Goldman Sach’s largest internal hedge fund – Global Alpha). Similar models run by the likes of AQR, Citadel and their ilk, were doing the opposite of what they were supposed to do. But after a terrifying week in which AQR is rumored to have lost $500mn to $ 1 bn in a week, GS recapped its fund, the large scale liquidation stopped and models started working. As Andrew Lo, a professor at MIT’s Sloan School of Management, observed in a September 2007 paper on the event, an “apparent demand for liquidity” that week “caused a fire sale liquidation.” The broader stock market however, was relatively unaware and unaffected by this event. The quants stuck to their models in a very tough environment. However, this was just a precursor to the real crisis which hit in 2008.

Tough Times don’t last, but Robust Systems do

Asness is known to have said that for every year that strategies don’t work, he ages by three years. And that should be a message to those claiming that systems/quant/rule based investing can over come all the biases and emotions of the fund manager. It does however, put in place a robust and strong conceptual framework in place. This doesn’t work for many. Most people who take up investing or trading in the first place, are drawn to it by the freedom and unstructured environment that this field offers. However, there is a paradox here. You are still bound by the rules of the market. And every now and then, strong hurricanes and typhoons will hit the market. We have had many 1 in a 100 year flood situations with increasing regularity. This tests the faith of the investor in his system and processes. He may incorporate some changes in the model, but only after careful consideration and evidence to do the same. He will not keep tweaking the system based on what worked last week or month. The bar for making changes should be quite high.

This is like a live situation. or a beating heart surgery. Earlier, during a bypass or any cardiac surgery, hearts used be stopped and patient was put on an artificial heart-lung machine. But now doctors have figured out how to do the surgery, without stopping the heart. Similarly the changes that a system investor will make are all in real time, when the system’s heart is still beating. It will never stop. A bit like refuelling an aircraft in midair.

Diversify among systems and/or factors

Even systems and factors have seasons or periods in which they do well and sometimes not so well. Value implemented systematically has performed poorly for over a decade now. In an extended period of low interest rates, favorable to growth or expensive stocks and where old business models have been challenged – cheap stocks have been out performed by expensive stocks.

Firms Using System Driven Strategies

However not all of them operate in similar time frames. Some of them are HFT traders where the holding period is in milliseconds and nanoseconds, while for others like AQR and Bridgewater is can be as long as a few weeks, months or even longer than a year. We are more like them. And as for RenTech, even though we have classified them as HFT, no one has any clue what they do, although they were caught as much other in the 2007 quantquake.

Our aim with this series is to showcase the building blocks of a systematic strategy for professional and DIY investor on a medium term time frame like a week. And we will do a deep dive into each year of performance of the strategy. We will try and set the economic and market context and background. And show how price driven quantitative strategies are different from and in some ways similar to qualitative and discretionary strategies. To give you a sneek peek, if you haven’t figured it out already, the two factors we are going to be using are Momentum and Low Volatility. Stay tuned for the next post.

Disclaimer: Nothing in this blog should be construed as investment advice. This is purely for educational purposes only.  Please consult an investment advisor before investing.