Quant funds: a game or an investment?

Low fees – thanks to the fact that the fund manager is not a human being but a machine – have distorted the world of investment. The problem is that most investors who hold these funds in their investment portfolios do not know how they work, nor what they actually do. For the most part, they are no more profitable than fundamental management funds – the traditional sort – and certainly not in the long term, but the fees make them very attractive to clients. These funds do not invest, in the true sense of the word—which is buying into a company because you believe in it—but rather they gamble, as if they were reading cards in a casino.

By Miguel Ángel Temprano

17 June 2022 Reading time: 4.10 mins

Those of you who read my articles, watch me on television or listen to me on the radio will know how little of a fan I am of quantitative funds. For those who are unfamiliar with them – although you may well have them in your portfolio – these are funds whose management is based primarily on a series of parameters, usually mathematical, which, when met, trigger the purchase or sale of securities; this is known in the trade as their algorithm.

They have one key feature that makes them attractive to buy and easier for banks to sell: their management fee is substantially lower than that of actively managed funds – that is, those where a human, rather than a machine, is behind every decision.

“A low commission for an investor may end up being the only reason for buying a fund”

Investing isn’t an art form, but neither is it a game. No one who genuinely invests their wealth – the wealth they’ve worked so hard to earn – would ever say that investing in the stock market is a game; that’s something only those who gamble away a few spare cash – usually just to see what happens – would say.

When you invest in listed securities, what you are actually doing is becoming an owner – albeit of a tiny share – of a company, usually one large enough to be listed on the financial markets. The people who work in these companies do not go to work in the mornings just to mess about; rather, they try to earn their wages through their daily work. This is why employees and managers must – and for the most part do – respect investors for what they are: the owners who pay their wages.

“Investing means becoming the owner of a business, which employs staff who are paid wages, manufacture products and contribute to the community”

Most investors are not speculators; rather, they simply lack the knowledge, the inclination or the time to understand either the balance sheets or the business operations of the companies in which they invest – and which they therefore own. That is why most investors delegate this task to professionals in the sector – or, as we like to say, in the industry.

We are supposed to analyse companies, their products, their management teams, their markets, and the current macroeconomic and geopolitical climate, and then decide in favour of one company or another, based on all these factors both individually and as a whole. In this way, we build portfolios and, depending on what is happening at any given time, we decide or advise on whether to buy or sell. In other words, we treat companies as what they really are: generators of wealth – not only for their shareholders, but for society as a whole – and as essential elements of the community.

And it has been this way for a long time.

“Computers have become so powerful that the world of finance is child’s play for them”

Two factors have changed this: one is the development of computers, which are becoming increasingly powerful and capable of generating and performing complex calculations in ever shorter times. It is often said – and the reality is that it is true – that the mobile phone we all hold in our hands, and which many of you will be using to read this column, is more than 1,000 times more powerful than the computer that helped put a man on the Moon in 1963.

The second, which is more recent and was partly driven by the 2008 crisis, is the creation by central banks of a vast amount of money supply, which has resulted in cheap money for a very long time.

This cheap – almost free – money has attracted many new investors and enabled many existing investors to access much more cheap money simply through financial leverage, creating a veritable investment frenzy.

“The glut of cheap money has sparked an investment frenzy that traditional fund managers have been unable to cope with”

In this situation, bankers were eagerly raising funds from investors, but when the money reached their companies, they encountered an internal problem: the managers could not manage any more money due to a lack of ideas on where to invest it, or perhaps it was not a lack of ideas – after all, once money is transferred onto paper, it is just zeros – but rather the impossibility of investing more money in certain listed securities, as they had exceeded the limits set by the supervisory body for buying and selling without restrictions.

And as is always the case, one thing leads to another. If I don’t have any more quality managers to create more funds, then I’ll use those computers, which now have an astonishing computing capacity. All I need is a mathematician or a team of mathematicians to devise a formula – the algorithm I mentioned earlier – that attempts to identify correlations or trends arising from events. But this, and you’ll have to admit, is more like the fortune-tellers in a casino than investing in companies that produce a good or a service.

“Financial institutions are currently the main employers of mathematicians and physicists; the reason is clear: they are the ones who develop the algorithms that generate a great deal of business for them.”

In other words, brilliant minds specialising in calculations, trends, statistics and who knows what else, set the parameters for what ultimately leads to a decision to buy or sell shares, without caring whether the company makes tights or grows tomatoes.

This means that the banker has more products to sell. And, technically speaking, there’s no limit to this, as the ‘new grey matter’ doesn’t analyse companies, but rather inputs some sort of parameters. And, interestingly, it’s cheaper, as the computer only uses electricity; it doesn’t eat every day or take the children to school.

And I’m sorry, but this doesn’t mean I’m proving myself to be ignorant, as the managers of quantitative funds claim I am. What they do isn’t securities management, even if that’s how they define themselves. Not by a long shot.

Investing is about believing, about trusting that a company will create value, and that is why I am involved – obviously hoping that this will happen and that the return generated through dividends and/or capital appreciation will justify it. The alternative is to go to a casino and count cards – legally, that is.

Quantitative investing has reduced investing to a game. And I’m not the first to say so, nor by any means the most important. Some of the very best fund managers have decided to leave this market, fed up with competing against a computer – not because they are any worse, but because they manage investments whilst computers merely gamble; yet they do so with such vast sums of money that, ultimately, they undermine the art of investment management.

And why are these funds being sold? Or rather, why do investors buy them? Quite simply because, as they haven’t got a clue, the bankers sell them a product that’s much cheaper in terms of fees.

I think of my late mother, who invested her meagre savings throughout her life. Knowing this, would she have entrusted her savings to a casino gambler to manage?

And my apologies to mathematicians and computer scientists – brilliant minds who devote thousands of hours of work to developing these algorithms; I have the utmost respect for them. I am not criticising them; I am criticising the model.

As I said to a quantitative fund manager the other day after giving a talk at a private banking conference. He complained to me about the comments I’d made on stage regarding this type of fund management. But note that, as well as complaining about what I’d said, he told me he managed a fund worth 7,000 million euros. How much damage could sudden movements by this fund cause to the market? Well, a great deal – which doesn’t mean he makes money, but rather that his algorithm could cause many savers to lose money unfairly.

I have said in some of these columns and in numerous forums that the market – that is to say, the stock market – always ends up putting everyone in their place. That if a company is sound and well-run, sooner or later the market will recognise its true value, and the opposite is true if it is a disaster. The computer couldn’t care less about any of this, and so the algorithm developed by those undoubtedly brilliant minds will have caused them to kick themselves a few times along the way, jumping on the bandwagon when it’s already too late.

In short, it is not that I am critical of quantitative management; it is that I am opposed to it. I am opposed to a layperson – as the vast majority of investors are – placing their savings in the hands of a machine, particularly without sufficient information on how the machine decides to buy or sell securities; for if that were to happen, I am convinced that more than half of investors would not agree to entrust their savings to it.