Quant Stew
(12 June 1997)

In connection with a piece he's doing, author Steven Mintz recently asked my thoughts on "what to do with quants?" Indeed, three decades after CAPM, what to think of this tasteless soup.

On the surface, quant stuff is a mechanical application of some one or several minds; i.e., artificial intelligence. Neither better nor worse than the designer. Put some testing device at the end of the process and you have an efficient, automated assembly line. Nothing radical . . . rather old Industrial Revolution stuff.

Then you can have a system that is mechanical and learns, in a loop. So-called dynamic quant (my term). Neural nets and, to a greater degree, genetic algorithms do these things. Again, nothing new.

A couple of distractions come into the system. One is that it is unclear that the economic hand drives toward profit maximization (total return over whatever time period). The field of behavioral finance is growing, making the study of "agent" (institutional self-interest) respectable because it uses different terminology. For example, if you have a long-term pension plan and you want maximum long-term results and can't forecast, why own 40% in fixed income instruments?

Another distraction is the noise in the system . . . partly discontinuous time where markets pulse and do not flow in even time units (hence little serial price correlation). Another is so much irrelevant information that you don't know the drivers of results. And another is just plain chatter. Engineers know how to deal with signal noise, but investment people don't.

And, finally, why is it that quant tools that are almost universal like back-testing, with no basis in academic fact still used? Why are basic academic principles of statistics multiple tests, reproducibility, rigorous challenge of results hardly ever observed by the quant practitioners? Answer: they are too busy making money the old- fashioned way . . . promotion of their "unique" skills. Learning comes during periods of prosperity, we are told, and application during periods of adversity.

My thought is that you can run an historical thread of quant stuff from then to now, with philosophical barbs thrown every once in a while. Investment styles are selectively Darwinian in that everyone you talk with is a survivor and can demonstrate that some single mentality has been proven to be correct.

My thought? Be entertainingly skeptical.

- Dean Lebaron