What is Quantamental Investing?
Quantamental is an investment strategy that is used commonly by the hedge funds where human traders use the results generated by the artificial intelligence and machine learning to improve the performance of their funds and the same has been emerged by combining fundamental and the quantitative method or the approaches in order to buy various financial instruments such as stocks, bonds, derivatives, etc.
What Makes Quantamental Investing Different?
Through the years, investors have pursued new techniques to invest in companies and build portfolios. Warren Buffet, the billionaire investor, is one of the prime promoters behind fundamental investing and the most successful investor of all time. However, over the past 3-4 years, Mr. Buffet has underperformed the S&P market. We shall dwell on how and why this happened, but let us look at what fundamental investing and quantitative investing are.
The prices of any financial instrument (stocks, bonds, derivatives, etc.) are a measure of their value. The prime assumption of economists is that, with time, information flows from the known to the unknown, and as the information flows, the ability to realize the value of a financial instrument grows. That being said, there is always a difference between the price we pay and the value we get. If your methods are strong enough and you realize that price is less than value, you buy the instrument and wait till the value is realized and vice versa.
Fundamental analysis is a way to measure such value. If we take the example of a company, the company publishes multiple documents that try to explain what the company is doing currently, what it plans to do, and where it will stand. We look at the assets of the company and its liabilities. We try to measure what the future for the industry will be and how the company will fare with the overall growth of the economy. Considering all these, we can look at the book value of the company and other metrics that help us in gauging the value of the company. Once the value is measured, market prices just provide us with a trading route.
- Value > Price – Long the stock and wait
- Price > Value – Short the stock and wait.
With the growth of computers, coding, and processing power, it is not just with a fundamental analysis that we can realize profits. There is always a gap between the value an price of a financial instrument. In addition, as long as such a difference exists, there is a way to make profits out of it. Quantitative investing uses the principles of statistics, combined with machine learning, to see patterns in movements of prices and try to invest in multiple places.
There are hundreds of metrics that are available to analyze the trading patterns in the market; look at the movement of stock prices, look at the price of options, analyze the buying and selling patterns, look at trends, look at industry movements, look at correlated stocks. Machine learning uses such statistical inefficiencies in the market to gauge how the stock prices might move and use them as an investment strategy. In short, quantitative looks at just the prices and formulates trading strategies.
Quantamental investing, as the name suggests, uses both of the above strategies to invest in companies.
Below are the examples of Quantamental Investing
The ability to implement strategies looking at fundamental and quantitative metrics is quite interesting. One such interesting scenario is: JC Penny outperforming the markets in the second quarter of 2015. Such positive results suddenly led to increasing at a price of 10%, and every one of the major investors was caught off-guard. However, there was one company, RC Metrics, a big data firm for investors, that used the satellite imagery of JC Penny’s parking lots to invest the company.
RC Metrics realized that the number of cars in JC Penny’s parking lots, which are counter using satellite imaging, is continuously rising. This, a piece of data that might be let off as trivial, is picked by the algorithms as a helpful metric and used to invest in the company. Everyone was surprised by the profits, not RC Metrics – they were prepared. This is a positive side of how Quantamental investing can be used.
To see when and where Quantamental investing is currently implemented and how it affects the trading strategies in investment companies, let us look at one of the most famous events of financial history – The Flash Crash.
2010 Flash Crash is a financial event where machine-led algorithms triggered a sell of causing a sudden crash in the market without any reason. However, in about an hour, the market regained its previous status. However, imagine the loss it caused to margin traders – who trade not on the full amount, but on margins. Billions of dollars were lost, and some traders lost their entire savings. There are many theories about how it happened, but one famous theory is that the machines started selling after Associated Press’s Twitter account was hacked and a fake tweet regarding a white house bombing was tweeted.
Algorithms, which are trained to learn, used Natural Language Processing to read this tweet and realized that something negative and big was about to happen. It is a very basic metric – something wrong has happened in the government, and it will affect the markets. This is how fundamental strategies work – gauge the scenario and act on it. However, it was not triggered by humans but by machines. In addition, once one machine triggers the selloff, the algorithms are trained to act quickly. In a scenario of falling prices, they assume the worst and trigger a further selloff. It snowballed into a crash, and markets are down by 9%.
The Dow Index lost about 998 points in a span of one hour. All this, because one machine looked at a tweet and began to sell. This is another side of Quantamental investing. The idea behind it might be right – but the implementation of machine learning algorithms to act with human intelligence is not yet as advanced as it should be to handle such scenarios.
Types of Quantamental Investing
#1 – Option Strategies
A Quantamental strategy involving options will work along the following lines :
- Scrub through thousands of equities
- Look at the respective option chainsOption ChainsAn option chain is a detailed representation of all available option contracts for an asset. It provides a quick picture of all available put and calls options of the asset with their pricing, volume, open interest details to analyze and take appropriate and immediate actions.
- Calculate the options that have the highest chance of yielding pay off.
- Add fundamental analysis to the same.
- Reassess the probability and price of the optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date..
- Formulate appropriate strategies
#2 – Macro Strategies
- Look at all the past economic data
- Predict the future markets based on current conditions using fundamental analysis
- Predict arbitrage opportunities using big data and formulate trading strategies.
- All investing is a measure of information and analyzing it. The ability to use quantitative methods to analyze the fundamental information is a step forward towards more open financial marketsOpen Financial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces..
- Quantamental investing is, by essence, a better method of realizing value than the fundamental or traditional investing.
- Quantamental investing increases the flow of information and finds a reasonable way to use the information in assessing the value.
- Machine Learning algorithms are black boxes, and we can never gauge how sudden events have to be handled.
- The ability to manually analyze the value of the financial investment goes down, and the future algorithms will reflect the same.
- Incidents like Flash Crash can be more common.
- Investment companies have to be aware of methods that the competition uses to trigger the machines – Humans have an intuitive sense, but not machines.
Quantamental Investing is a type of investing where mathematical principles and statistical methods are used along with traditional finance methods to invest and build portfolios. It is a blend of fundamental investing and quantitative investing.
Like all technologies, Quantamental investing has its own merits and demerits. It might change the future of the financial investments in an extremely positive direction – where true value is equal to market value, or in the direction of disasters – more incidents like the flash crash. Moreover, like every other technology, it is upon the humans to see what can be done using these investing methods. Nevertheless, before that, we should not be clouded by the ego of what can and cannot be done, that we forget to see what should and should not be done.
This has been a guide to what is Quantamental Investing and its definition. Here we discuss the types of quantamental investing along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –