Computer-based models to replace the investment advisor?

Man versus machine

By Bob McDowall, IE4C • Get more from this author

Posted in Business, 21st August 2006 12:31 GMT

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Analysis A number of recently published features and surveys evidence the continued growth in quantitative investment.

Quantitative investment is based on the deployment of computer generated investment decisions. It is reputed to be growing at 20 per cent per year. Major conventional fund managers as well as hedge funds are increasingly deploying computer-based models to make investment decisions rather than relying on human judgement - or is that a myth?

Quantitative investment managers use a model to identify sets of characteristics for their investments. Computing power is now relatively cheap. Obviously, computing power can access data almost instantaneously and simultaneously. Asset classes and financial instruments within those asset classes can then be screened and investments are selected. They reflect the manager's views.

These models normally determine the investment decisions and so replace the traditional portfolio manager's role. It is contended that this approach eliminates human emotion and personal bias, which can impede effective portfolio management.

More importantly, the models provide insight into market inefficiencies to be applied rapidly across asset classes and the vast number of financial instruments within those asset classes. Whole markets can be analysed daily for buy and sell indications at an individual instrument level. This enables portfolios to contain a larger number of instruments and reduce risk through greater diversification of the portfolio.

Computers have not taken over the investment process. Human qualities are required to set the criteria and parameters for data collection and analysis. Here the investment stars still have their place - a creative and efficient human portfolio manager to extract the value from quantitative data.

It is a complete myth that quantitative investment managers are nerdish boffins working under the direction of an all-powerful computer model. It is equally a myth, perpetuated by some technology providers, that there is reliance on a "black-box" stereotype. Dependency on programming and computer nerds has not replaced the dependency on star investment managers.

Quantitative investment managers distinguish themselves by their processes, "which combine people and technology in a framework that rigorously assesses cost, risk and return, which sets them apart from less successful managers".

Trading is a function, where it would be possible and highly irresponsible to construct/build a completely automated quantitative process. Trading is not a mechanical process. Trading is influenced by relationships, trust (and the lack of it!) and gamesmanship. Equally, trading relies on much more than the application of intuition or "gut feeling". The key role of traders is to provide the balance between pure judgement and systematic solutions.