IT IS eight
in the morning. Jonathan Lamb has just sat down in front of
his computer in the open-plan offices of Barclays Global Investors
(BGI), the world s second-biggest asset-management group. With
his blond beard, glasses and tweed jacket, Mr Lamb could be
mistaken for a scientist rather than a fund manager in the City
of London. That is not such a mistake. While he was asleep,
a sophisticated computer model researched the entire British
stockmarket for him. Pulling up a screen called AlphaGenerator
, he now peruses grey columns of shares, ranked by numerical
scores. By ten o clock, Mr Lamb will have used these scores
to order hundreds of small trades to fine-tune his clients share
portfolios. BGI belongs to a growing number of asset managers
that consider themselves part of a new school of investing.Their
basic creed is that, in broad terms, the best returns are to
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trying to replicate a particular index; but that sophisticated
computer models can also exploit short-term anomalies to generate
returns greater than that index. Some guys at Fidelity think
they can outperform the market because they re at Fidelity,
says Kevin Coldiron, head of European research at BGI. We ve
got 200 guys walking around this office believing in the null
hypothesis: that the market can t be beat. Their view has found
favour among investors, who have recently been pouring money
into the likes of BGI. Which invites a question and also offers
a seeming contradiction. Is the new school right that the market
cannot be beaten? And, if so, why do its adherents still try
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The old school
thinks that fund managers can beat the market through painstaking
analysis of economic fundamentals, better information (company visits,
say) and a knack for predicting what the future holds. Ultimately,
says Chrissy Keen, a director at Fidelity, the world s largest fund-management
group, it s the individual fund manager s skill, whether it s [Fidelity
s] Anthony Bolton or Warren Buffett.
Unfortunately, with rare exceptions, traditional fund managers have
been underperforming their market benchmarks for years (see chart).
Value managers, the most traditional of these, who specialise in
buying shares that they deem to be undervalued, have done particularly
dismally. In part, their woes can be explained by the long bull
run, which has favoured large-capitalisation stocks at the expense
of the smaller companies on which value managers tend to concentrate.
Disenchantment with old-style fund managers has driven investors
away from active managers and into passively managed funds that
track a stockmarket index (and charge lower fees). Money has flooded
into the biggest index-fund managers such as BGI, State Street and
TIAA-Cref. About 10% of pension-funds money is now invested in index
funds, up from 4% in 1993. But mere index-tracking is a low-margin
business. State Street, for example, now charges between five and
ten basis points (hundredths of a percentage point) of the value
of a fund s portfolio, and sometimes less. To keep margins up and
to attract more money, passive managers have started to offer clients
additional layers of active management that promise to outperform
an index.
Except that their active is not at all like the traditional sort.
For many fund managers it does not involve any big bets: the aim
is to try to outperform an index only a bit. Instead, they take
lots of little bets. Whereas a traditional fund manager holds shares
in 20-80 favoured companies, a new-schooler may have thousands of
positions. And these positions are increasingly driven by so-called
quantitative techniques.
Quantum leap.
Such quantitative (as opposed to traditional, qualitative) investment
strategies are hardly new. Crunching numbers to spot trends or patterns
that repeat themselves has been around for at least a century; the
first charting techniques were developed in Japan s rice market
in the early Edo period. A few funds have long incorporated quantitative
techniques into black boxes and relied on the ideas that they spit
out. Two things have changed, however. One is a growing acceptance
of quantitative techniques by mainstream investors, such as pension
funds and even retail mutual funds. Nicola Meaden, director of Tremont/TASS,
a specialist-investment consultancy, reckons that the number of
fund managers tracked by her firm who use such techniques has quintupled
this decade, with most new converts joining up in the past couple
of years. The second is that, with the falling cost and greater
availability of computing power, managers increasingly use these
methods not as their sole basis for investing, but to tweak their
basic portfolios.
In the short term, they think, many tiny buying and selling opportunities
may present themselves, for the simple reason that all those participating
in the capital markets are (stereotypes notwithstanding) human.
This makes their behaviour mostly rational and predictable and so,
in theory at least, possible to take advantage of. What is scientific
about the new school is their method of postulating hypotheses and
then testing these against historical data to reject, refine or
corroborate them.
For example, Avinash Persaud, State Street's head of research, has
long suspected that capital markets tend to follow certain predictable
behavioural patterns. To test his hunch, he assumed a perfect world,
where, say, 13 different bond and currency markets move randomly
in relation to one another, giving rise to over 6 billion possible
permutations of their relative performance. But by endless crunching
of historical data, Mr Persaud has discovered that 12 of these possibilities
occur four-fifths of the time. These regimes , as Mr Persaud calls
them, include such themes as a general climate of risk appetite
or risk aversion and perceptions of a cyclical upturn in the world
economy. At the moment, Mr Persaud suspects that just such a regime
is responsible for driving up oil prices and commodity-linked currencies
such as South Africa s rand and the Australian dollar, as well as
for pushing up bond yields and equities in cyclical industries.
Or take stock selection. The biggest single driver of a company
s share price tends to be its profit forecasts. Traditional fund
managers spend most of their time trying to get future earnings-per-share
numbers right , in order to see whether their view diverges from
that of other analysts. The likes of BGI, by contrast, care little
for the numbers as such. Instead, BGI postulates that what drives
share prices are changes in profit forecasts, ie, upgrades or downgrades,
and, crucially, those made by certain analysts more than others.
Moreover, BGI has noticed, upgrades and downgrades rarely happen
in isolation; as soon as one analyst upgrades, other brokers come
under pressure to follow suit. So BGI monitors 4,500 analysts on
a daily basis to spot trend signals early.
Critics have plenty of doubts about all this. Paul Greenwood, an
analyst at Frank Russell, a pension-fund consultancy, reckons that
quants , thanks to their small bets, have not outperformed the indices,
but simply bled more slowly than other active managers. The quants
counter that all they are doing is trying to enhance the returns
available from an index for almost no extra risk and at a lower
trading cost, since their trades have less market impact. And BGI,
for one, has been outperforming.
Other sceptics argue that, impressive as they might appear, such
methods work only briefly, if at all. The most elegant behavioural
theories may turn out to be little more than chance outcomes of
data-mining over a certain period in the past giving them little
or no predictive value for the future.
And it so happens that in the past few weeks value fund managers
have done better than the racier newcomers, as investors have started
to look at cheaper, smaller companies. They may do better still
if Wall Street turns down sharply. Investors might then sell what
is easiest ie, shares in big companies. That would benefit the traditional
types who have concentrated on the smaller fry. Every dog, after
all, has its day.
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