Monday, January 22, 2007

The Librarians

“Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary results.”
Warren Buffett, Berkshire Hathaway, 1994 Chairman’s Letter.

There is no shortage of investment disciplines, philosophies and methodologies out there. There are those who look at companies’ fundamentals, there are those who read charts and then there are the quants. The quants gather gobs of data, form hypotheses which are tested against historical data and tweak their computer models to forecast future returns. We all know how reliable past performance can be as a predictor of future returns. In his 1990 Chairman’s Letter, Warren Buffett wrote, “Beware of past-performance ‘proofs’ in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.”

To be sure, venerable quantitative shops such as Renaissance Technologies Corp. and D.E. Shaw have amassed enviable track records and kept their investors happy. One has to wonder though if the market has not ironed out the inefficiencies which have been exploited by these whizzes over the past two decades.

It is interesting that D.E. Shaw’s web site has a section on Qualitative Strategies noting that a large share of the firm’s attention is now spent on identifying “profit opportunities by human experts” and that such strategies “have accounted for much of the firm's growth over the years, and now represent an equally important element of its strategic focus.” Renaissance’s site is too exclusive to post any such information.

Then there was the recent Businessweek article, “Outsmarting the Market”, profiling Barclays Global Investors (BGI), the subsidiary and quant group of parent Barclays PLC. Impressive indeed. $19.9 billion of above market returns or “alpha” over the past five years. 2800 pension funds and institutional investor clients. Billions under management - $370 billion to be exact. Alas, all the fancy research, hypotheses and models for a mere 1.64% above market return on average. This is done by spreading bets across a wide numbers of investments. The idea of a concentrated portfolio is taboo to say the least since that would entail too much price volatility, which as we have discussed before, is wrongly equated with risk.

The quants don’t care much about the companies they are ‘investing’ in. Businessweek writes that the “whole sprawling human drama of business is of no interest to Barclays’ researchers, who never venture out to call on a company or tour a store or a factory.” I wonder if it was the same lack of analysis that lead to Barclay’s acquisition of BGI for $443 million in 1995.

1 comment:

Eclectic Contrarian said...

Interesting topic that I've thought about a bunch. I posted some thoughts here: http://contrary-cents.blogspot.com/2007/01/value-investors-defense-of-quant.html

As always, great blog. Hopefully the post generates some points worth thinking about.