What if I could introduce you to an investment style for equities that can soundly beat the market over time and only requires a few days a year of work? Interested? I thought so. Today I want to introduce you to Quantitative Investing and why you should consider incorporating it into your investment portfolio.

Quantitative Investing is a fancy term for systematic, structured investing that automates buy and sell decisions. It represents a combination of passive and active investing. Other terms for it are automatic investing or computerized investing. Many investors are familiar with some very infamous stories of quantitative investing gone wrong, the most prominent example being the failure of Long Term Capital Management in the late 90s. And there are a slew of hedge funds the run very complicated ‘quant’ strategies. But quantitative investing can be quite simple as well, and yet very effective. In a way, the S&P500 index is an example of a quantitative strategy. The S&P500 is a large cap strategy where the buy and sell decisions are decided for the investor. The active part here is the specific choice of large cap stocks. Companies are added and deleted every so often by the S&P committee thereby automating buy and sell decisions. Personal and emotional decisions don’t come into play at all. This simple quant strategy has outperformed over 70% of mutual funds over time. It never panics, has second thoughts, or varies from its core strategy. And there in lies much of its strength and why indexing outperforms most active managers over time.

But there are other simple quantitative strategies that outperform the S&P500. One famous example is the “Dogs of the Dow” strategy. This is a strategy that buys an equal amount of the 10 highest yielding DOW stocks every year. Pretty simple. From 1928 through 2009 this strategy returned 11.22% per year vs 9.12% for the S&P500. There are many other examples of outperforming strategies that take advantage of time tested factors that consistently beat the market over the long term. I’ve discussed the 3 key factors in outperformance before, they are value, small capitalization, and momentum. I’ve also discussed one way to take advantage of these factors, by indexing to them through ETFs. This is yet another example of a quant strategy. Now comes they real exciting part. You can do even better than just indexing to these outperformance factors through ETFs. The first thing to do is to find out which are the best quantitative strategies. Fortunately there is a great resource, the bible of quantitative investing so to speak, the book What Works On Wall Street by James P. O’Shaughnessy first published in 1996 and now in its fourth edition, published in 2011. This book goes through hundreds of quantitative strategies and ranks their historical performance, risk, and many other parameters. As a teaser, in the table below I excerpted the top performing (ranked by sharpe ratio – risk adjusted return) strategies from the book with a comparison to the S&P500. Don’t worry about the strategy descriptions, they are well described in the book.

Impressive to say the least. All the top strategies use some combination of the outperformance factors (value, small size, momentum). The top strategy, Trending Value, combines all 3 factors to achieve some pretty amazing results. It has a compounded annual return of 21%, a sharpe ratio of 0.91 – well over 3 times the risk-adjusted return of the S&P500, $10K turns into $48M vs $523K for the S&P500, and the max drawdown is about the same as the S&P500! These top 5 strategies are no fluke. There are in fact 222 strategies documented in the book that outperform the S&P500 on a risk adjusted basis. And many of them are implementable by the individual investor, a large topic I will address in future posts. You may be asking why doesn’t everyone do this? Most of that comes down to lack of knowledge and probably more importantly lack of discipline and consistency in investing. Hell, most people can’t even follow an indexed buy and hold portfolio. What also impressed me is the little work required to implement these strategies. In all of these strategies, once you have the results of the strategy, say on Jan 1st of the year, you buy and hold the stocks for 1 year and then re-run the strategy. The rest of the year you do some simple monitoring for acquisitions, financial scandals, etc… and that’s it. On value for effort spent this is truly compelling and is what finally made me decide to start putting some real money behind this concept. I think most investors would come to the same conclusion. Even active traders need to ask themselves if their results are worth the time as compared to quantitative methods.

The discovery of quantitative investing and the purchase and study of What Works On Wall Street is one of the best investments I’ve ever made. I can’t recommend the book enough. I’ve studied many of the strategies, learned how to implement the strategies with available low cost tools, paper traded the top strategies for over a few years, and have committed real money to a few of them. The results have been impressive especially considering the time spent once you get up to speed. And wait until I tell you what they can do for retirement withdrawal rates! At this point I expect quantitative strategies to become the major equity allocation in my portfolio. I think many investors would find the same results. In the next several posts I’ll go into some more detail on how to implement quantitative strategies and also show you how they can benefit retirees.

Sounds interesting. Looking forward to your take on the benefits for retirees since I plan on joining that group fairly soon.

Paul, this method sounds a bit complicated; combining value, small size and momentum. But it sure has great results. Look forward to learning more from you.

You’ve described your value (high dividend MLK’s), small cap and momentum (IVY) strategies before. Are you moving away from these, or does the quantitative method just combine the best of all?

Nathan, the complicated part is learning to run the screens. Once you have that down, its a matter of running them once a year to generate the stocks to buy and doing some simple monitoring throughout the year.

I don’t believe in putting all my eggs in one strategy so I will not move away from IVY or some stellar individual stocks, like Fairfax, but I will pick less individual stocks and trade less as I move to these quant strategies. As far as return for time spent, which I always look at, its hard to beat the results of quantitative strategies. More to come….

Paul

Interesting post! Since this is not only about the strategies, but about the fact that they can be automatized –

is there an open source implementation of those 5 strategies (or even only the top one)?

If yes: what stops you (or others) from using those?

If no: what stops people from writing such a software?

And – would a wide use of those strategies have a negative effect on their effectiveness?

No, there is no open source implementation. And that’s a good thing IMO. It takes some work to get these set up, although its not that complicated but probably complicated enough to keep most away. The tougher part is having the emotional discipline to trust and stick with the strategies. That’s what keeps these quant strategies working. Why would the simple ‘Dogs of the Dow’ strategy work after all these years? Why would value (low P/E, low P/B, etc) outperform after all these years? Rational decisions don’t happen all that often in financial markets.

Paul

Paul,

Thanks for the recommending O’Shaughnessy’s book, this has really changed my mindset about investing. Another similar book I found is The Little Book That Beats The Market, any thoughts on it?

Conrado

Conrado,

the Little Book That Beats the Market is a great book. It is another example of a quantitative value strategy that has done well over time. The creator of the strategy Joel Greenblatt is a great value investor. He keeps a website with a free screener where you can get the stocks that meet the screen criteria.

I have a couple of issue with the magic formula strategy. One, I can’t run the screen myself because the details of the screen aren’t available. Also, I’m missing a bunch of historical data to allow to me completely evaluate the screen. Data such as risk adjusted returns, max drawdown, base-rates, etc… So, all in all I prefer the strategies from What Works On Wall Street that I’ve covered.

Paul