by Corey Hoffstein, Newfound Research
This post is available as a PDF download here.
- Quant is a broad word with many job descriptions in finance. In asset management, a quant is someone who applies mathematical (usually statistical) techniques to analyzing the securities market, usually with an eye towards identifying investment opportunities.
- Quants rely on factors: systematic investment approaches that capture and explain the return difference between different cohorts of securities.
- Factors are all about buying baskets of things; quants like to avoid idiosyncratic risk because we do not believe investors are compensated for bearing the additional risk.
- For a market to function, someone has to perform information discovery on individual stocks. Can this role be filled by quants or does the market require stock pickers to function?
“Quant” is a word of with many connotations. For some, they are the numerical wizards conjuring new sources of alpha. For others, the out-of-touch wonks who caused the financial crisis.
At the broadest, most sweeping generalization, quants specialize in applying mathematical techniques and methods – mostly statistical – to financial markets.
In finance, there are all sorts of quants. Some work deriving new pricing theories for derivatives; others work managing and modeling risk; and still others – like us – work to identify empirical pricing relationships for building portfolios.
We’ll dedicate this commentary to our parents and significant others, who still have no idea what we do for a living.
More Risk, More Reward
In the 1960s, the Capital Asset Pricing Model (“CAPM”) was introduced. CAPM provides a model for pricing an individual security. Known as a “single factor” model, CAPM modeled a stock’s excess return as being one-part overall market return and one-part idiosyncratic return.
Here the Greek letter that looks like a "B" – known as “beta” – estimates the stock’s sensitivity to market returns. The Greek letter that looks like an "E" at the end of the equation is the idiosyncratic component.
We’ve all heard the saying, “no risk, no reward.” In the case of financial markets, the question is: “which risks earn reward?”
As the theory goes, not all of them do. CAPM states that investors should only be compensated for bearing market risk but not for bearing idiosyncratic risk. The argument is that beta is undiversifiable: build a portfolio of stocks and the beta component remains. The idiosyncratic risk, on the other hand, can be diversified away.
For example, a portfolio of 30-40 stocks is typically sufficient to reduce idiosyncratic exposure enough that only the shared market risk remains. If we did earn compensation for bearing the risk, we could create an arbitrage. We would build a portfolio of 30-40 stocks to diversify away our idiosyncratic risk – but not the reward! – and then short the broad market to eliminate our market risk. Hence, it holds that we should not be compensated for bearing idiosyncratic risk.
Here we’ll point out that CAPM stands in direct opposition to the practice of stock picking. No amount of understanding of idiosyncratic, company specific risk should lead to an expectation of higher returns.
Being Compensated for Non-Market Risk
When a quant says, “risk factor,” what they mean is a characteristic that helps explain why one stock did one thing and another did something else. In CAPM, the risk factor was the market. If the market goes up, stocks with more market exposure should go up more while stocks with a lower exposure will go up less.