Most quantitative investors merely seek to implement investment processes that are easily understandable to traditional investors, albeit relying more heavily on numerical techniques. Indeed, without knowing it, Islamic investors are already much closer to the world of quantitative investment management than they might realize.
The process of assessing Shariah compliance itself makes extensive use of quantitative techniques. Given the scale of the task, it could hardly be otherwise. The Standard & Poor’s Broad Market Index (BMI) contains over 11,000 stocks, each of which must be regularly assessed in terms of a range of financial criteria to gauge their suitability for inclusion in the Islamic Indices.
Financial assessment via accounting-based ‘screens’ can be conducted across a large universe with comparative ease, allowing Shariah scholars to quickly identify those companies that operate with excessive debt levels and/or high cash holdings.
Moreover, all market participants ultimately seek the same outcome. Regardless of whether they are quantitative in nature or choose to adopt a more traditional ‘fundamental’ approach, the goal of all investors is to achieve superior investment returns at lower levels of risk.
Quantitative investors use many of the same tools that would be familiar to their traditional counterparts, such as the price to earnings ratio (PER), revisions to analysts’ forecasts and measures of management efficiency such as return on equity (ROE). However, despite having a common goal and using similar tools, there are a number of key differences that distinguish how the two approaches are implemented in practice.
Traditional investment management is based upon the in-depth examination of a company’s strategic positioning, management strength and competitive threats. The valuation of a company’s equity can also be a complex and time consuming business, as anyone who has assembled a detailed set of financial forecasts and a discounted cash flow model will attest. The time and resources required to conduct fundamental research therefore limits the opportunity set available to traditional investors, in addition to constraining the speed with which they can react to new information.
Quantitative analysis, by contrast, is capable of dealing with information for all companies in the investment universe at the same time. Since most work is computer-based, processing times are also faster, meaning that a quantitative strategy is far less constrained with respect to potentially profitable opportunities than a traditional manager would be.
Quantitative techniques are therefore particularly well suited for investors dealing with Shariah benchmarks, given that the financial screening criteria used to create them will alter the set of investable companies every time the index is recalculated.
It’s not just a question of how much information investors are capable of processing, however. Equally important is the way in which they process it. We are all unfortunately prone to what psychologists refer to as ‘cognitive biases’: habits of processing information that can lead to systematic errors in decision making.
Whilst often useful and a convenient way of saving time, the everyday mental shortcuts that lead us to make cognitive errors are particularly dangerous for investors. Whether simply following the crowd into hot stocks and overlooking out-of-favor issues, or overestimating your ability to forecast correctly simply because you were right the previous time, cognitive biases can have a material impact on investment performance.
Traditional active management relies heavily on the subjective judgments of individual analysts and managers, making it susceptible to cognitive biases. A quantitative investor, however, will create and most importantly adhere to a robust set of investment rules; a process which significantly reduces the scope for cognitive errors.
Moreover, quantitative strategies can be designed specifically to exploit certain cognitive biases – strategies that focus on momentum, for example, are based on the statistically demonstrated observation that investors often under-react to new information. A company that releases good news may therefore see its share price outperform the market over the next weeks, or even months. Equally, bad newsflow may be followed by a long period of under-performance.
By their very nature, quantitative portfolios offer a number of desirable attributes that should appeal to all investors: specifically transparency, consistency, repeatability and risk control. These attributes are of critical importance for investors wishing to understand how their portfolio manager is seeking to beat the market and, just as importantly, how the actual returns were generated. Portfolios managed using quantitative techniques are better suited to fulfilling such requirements since the models driving them are clearly expressed as a set of transparent investment rules, consistent and demonstrably repeatable via simulated ‘back tests’ and easier to manage in terms of risk through statistical optimization. If good performance is to be repeated in the future, visibility over these factors is vital.
The investment team at Reliance Asset Management (Malaysia) have been successfully running Shariah compliant portfolios for a number of years now. The WSF Reliance Global Shariah Growth Fund was launched in August 2010. The fund selects investments from the S&P Developed BMI Shariah index using the proprietary ‘cognition’ stock selection model.
This is a computer-based expert system which observes, and makes decisions based on, most of the indicators that traditional investors would analyze, but in a systematic, data-intensive way – i.e. using a quantitative approach. ‘Cognition’ attempts to be unwaveringly rational and risk-controlled in undertaking the process that it uses to formulate a portfolio of global Shariah compliant equities.
To date the strategy has produced encouraging levels of excess return. However, and more importantly in our view, the volatility of those excess returns has also been relatively low, despite extremely volatile market conditions. This represents a validation of our underlying investment strategy, but also serves to illustrate an important feature of quantitative strategies in general: namely, that they tend to produce much better risk-adjusted returns than traditional fund strategies, because they are capable of targeting very specific sources of excess return – in our case ‘style trends’ – and at the same time rigorously reduce unwanted risks from the portfolio.
Our approach to beating the market involves understanding which types of company offer the most compelling combinations of investment ‘styles’, such as value, growth, or momentum. It is important that these definitions reflect economic reality.
For example, a sector analyst covering the biotechnology or telecommunication sectors might consider the PER a relatively useless valuation metric, since profitability amongst the companies they cover would likely be held back by investment in research and development or new subscriber acquisition. Fortunately, we don’t need an army of analysts to tell us which factors to use in every sector around the world.
Correlation (factor) analysis, which quantifies the nature of the relationship between two variables, offers a powerful tool for answering such questions. This approach can be used to understand, for example, whether PER is a useful metric in any given sector, or whether value as a style is currently more relevant for a particular sector than momentum. The ‘cognition’ process undertakes similar factor analysis across a universe of around 2,500 Shariah compliant stocks globally to try to understand which variables are most important, and more importantly, which characteristics are most likely to lead to share price outperformance in the future.
In terms of style relevance, ‘where’ and ‘when’ are also of critical importance. Different geographic regions may experience very different macroeconomic conditions at the same point in time – one need look no further for comparisons than the dynamic growth economies of Asia and the debt-laden economies of Europe and the US.
Moreover, these relationships will undergo constant change, as economic conditions evolve over time. It is therefore advantageous for a quantitative strategy to analyze different regions and sectors separately, in addition to retaining the ability to change over time as the economic cycle unfolds.
The investment process outlined here could, of course, be applied to any investment universe, provided sufficient data is available to perform the supporting factor analysis.
We can all learn to be better investors. Human insight and intuition can, in our view, be substantially enhanced within a framework of statistical checks and balances that help to offset our tendencies towards impatience and irrationality. Quantitative strategies represent the efforts of ordinary investors to implement their investment ideas in a more disciplined manner using standard statistical techniques. Far from being a mathematically incomprehensible conception, now that data and computing power is universally available, we would argue that everyone should attempt to bring quantitative insights into their investment approach. And Shariah compliant investors have always been ‘quants’ in any case!
Ian Lancaster is CEO of Reliance Asset Management Malaysia. He can be contacted at
[email protected]
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