when quantitative investment strategies “add up to fraud”

Yesterday’s online Financial Times contains an article titled “When use of pseudo-maths adds up to fraud.”  It references an academic paper (which I haven’t read yet–and may never) which concludes that while quantitative management strategies may look impressive to neophytes, many are mathematically bogus.  This could be why they often fail deliver the superior investment performance they appear to promise.  Anyone with mathematical training needed to construct such a statistical stock-picking system should know this.

Quelle surprise!, as they say.

There’s a powerful cognitive urge to simplify and systematize data.  But that’ not why investment management companies typically create the mathematical apparatus they tout to clients.

The reality is that investment management has a large right-brain component to it.  It depends on individual judgment and intuition honed by experience.  This fact makes clients uncomfortable.

Typically the company treasurer, or other person in the finance department who is in charge of supervising the company pension plan, has little or no investment training or experience.  He may know corporate finance, but that’s a lot different from portfolio investing.  Suppose the manager I just hired begins to lose something off his fastball, he thinks.  He tells me he reads 10-Ks, but suppose he just goes into his office, takes an hallucinogen and picks stocks based on the visions he experiences.  How can I explain this to my boss if the pension plan returns go south?

That’s why his first step is to hire a third-party pension consultant.  It’s not necessarily that the consultant knows any more than the treasurer–in my experience, the consultant probably doesn’t.  Hiring an “expert” is a form of insurance.

Selecting a manager with a quantitative stock-picking system is another.  The supposed objectivity of the system itself–safe from emotions or other human foibles–is a second form of defense.

Up until now, the apparent safety net created by hiring the consultant and selecting a recommended manager who relies on “science” instead of intuition has been enough to clinch the deal for many quantitative managers.   Of course, while this decision may make the treasurer feel better–and may be an effective defense as/when the quantitative system in question blows up–it doesn’t eliminate the risk in manager selection.  It simply shifts the risk fulcrum away from the human portfolio manager to the statistician who has constructed the stock selection model.  The paper the FT references, “Pseudo-Mathematics and Financial Charlatanism,” argues that, empirically, this is a terrible idea.

I wonder if anything will come of it.

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