What is Quantamental Investing?

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What Makes Quantamental Investing Different?

Warren Buffet, the billionaire investor, is one of the prime promoters of fundamental investing and the most successful investor. Through the years, investors have pursued new techniques to invest in companies and build portfolios. However, over the past 3-4 years, Mr. Buffett has underperformed in the S&P market. We shall dwell on how and why this happened, but let us look at what fundamental and quantitative investing are.

The Fundamental

The prices of any financial instrument (stocks, bonds, derivatives, etc.) are a measure of their value. The prime assumption of economists is that, with time, information flows from the known to the unknown, and as the information flows, the ability to realize the value of a financial instrument grows. That being said, there is always a difference between the price and the value we get. If your methods are strong enough and you realize that the price is less than the value, you buy the instrument and wait till the value is realized and vice versa.

Fundamental analysis is a way to measure such value. If we take the example of a company, the company publishes multiple documents that try to explain what the company is doing currently, what it plans to do, and where it will stand. We look at the assets of the company and its liabilities. We try to measure what the future for the industry will be and how the company will fare with the overall growth of the economy. Considering all these, we can look at the book value of the company and other metrics that help us in gauging the value of the company. Once the value is measured, market prices provide us with a trading route.

  • Value > Price – Long the stock and waitPrice > Value – Short the stock and wait.

The Quantitative

With the growth of computers, coding, and processing power, it is not just with a fundamental analysis that we can realize profits. There is always a gap between the value and price of a financial instrumentFinancial InstrumentFinancial instruments are certain contracts or documents that act as financial assets such as debentures and bonds, receivables, cash deposits, bank balances, swaps, cap, futures, shares, bills of exchange, forwards, FRA or forward rate agreement, etc. to one organization and as a liability to another organization and are solely taken into use for trading purposes.read more. In addition, as long as such a difference exists, there is a way to make profits.  Quantitative investing uses the principles of statistics, combined with machine learning, to see patterns in movements of prices and try to invest in multiple places.

Hundreds of metrics are available to analyze the trading patterns in the market; look at the movement of stock prices, look at the price of options, analyze the buying and selling patterns, look trends, look at industry movements, and look at correlated stocks. Machine learning uses such statistical inefficiencies in the market to gauge how the stock prices might move and use them as an investment strategyAnd Use Them As An Investment StrategyInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more. In short, quantitative looks at just the prices and formulates trading strategies.

Quantamental investing, as the name suggests, uses both of the above strategies to invest in companies.

Examples

Below are the examples of Quantamental Investing

Example #1

Implementing strategies looking at fundamental and quantitative metrics is quite interesting. One such interesting scenario is: JCPenney outperforming the markets in the second quarter of 2015. Such positive results suddenly led to an increase of 10%, and every one of the major investors was caught off-guard. However, one company, RC Metrics, a big data firm for investors, used the satellite imagery of JC Penny’s parking lots to invest in the company.

RC Metrics realized that the number of cars in JC Penny’s parking lots, which are counter-suing satellite imaging, is continuously rising. The algorithms pick this data that might be left off as trivial as a helpful metric and used to invest in the company. Everyone was surprised by the profits, not RC Metrics – they were prepared. This is a positive side of how Quantamental investing can be used.

Example #2

To see when and where Quantamental investing is currently implemented and how it affects the trading strategies in investment companies, let us look at one of the most famous events of financial history – The Flash Crash.

2010 Flash Crash is a financial event where machine-led algorithms triggered a sale causing a sudden crash in the market without any reason. However, in about an hour, the market regained its previous status. However, imagine the loss it caused to margin traders – who trade not on the full amount but margins. Billions of dollars were lost, and some traders lost their entire savings. There are many theories about how it happened. Still, one famous theory is that the machines started selling after Associated Press’s Twitter account was hacked and a fake tweet regarding a white house bombing was tweeted.

Algorithms, trained to learn, used Natural Language Processing to read this tweet and realized that something negative and big was about to happen. It is a basic metric – something wrong has happened in the government and will affect the markets. This is how real strategies work – gauge the scenario and act on it. However, it was not triggered by humans but by machines. In addition, once one machine triggers the selloff, the algorithms are trained to act quickly. In a scenario of falling prices, they assume the worst and trigger a further selloff. It snowballed into a crash, and markets are down by 9%.

The Dow Index lost about 998 points in one hour. All this is because one machine looked at a tweet and began to sell. This is another side of Quantamental investing. The idea behind it might be right – but implementing machine learning algorithms to act with human intelligence is not yet as advanced as it should be to handle such scenarios.

Types of Quantamental Investing

#1 – Option Strategies

A Quantamental strategy involving options will work along the following lines:

  • Scrub through thousands of equitiesLook at the respective option chainsOption ChainsAn option chain is a detailed representation of all available option contracts for an asset. It provides a quick picture of all available put and calls options of the asset with their pricing, volume, open interest details to analyze and take appropriate and immediate actions.read moreCalculate the options with the highest chance of yielding payoff.Add fundamental analysis to the same.Reassess the probability and price of the optionsOptionsOptions are financial contracts which allow the buyer a right, but not an obligation to execute the contract. The right is to buy or sell an asset on a specific date at a specific price which is predetermined at the contract date.read more.Formulate appropriate strategies

#2 – Macro Strategies

  • Look at all the past economic dataPredict the future markets based on current conditions using fundamental analysisPredict arbitrage opportunities using big data and formulate trading strategies.

Advantages

  • All investing is a measure of information and analyzing it. Using quantitative methods to analyze the essential information is a step toward more open financial marketsOpen Financial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more.Quantamental investing is, by essence, a better method of realizing value than fundamental or traditional investing.Quantamental investing increases the flow of information and finds a reasonable way to use the information to assess its value.

Disadvantages

  • Machine Learning algorithms are black boxes, and we can never gauge how sudden events must be handled.The ability to manually analyze the value of the financial investment goes down, and future algorithms will reflect the same.Incidents like Flash crashes can be more common. Investment companies have to be aware of the competition’s methods to trigger the machines – Humans have an intuitive sense, but not machines.

Conclusion

Quantamental Investing is investing where mathematical principles and statistical methods are used along with traditional finance methods to invest and build portfolios. It is a blend of fundamental investing and quantitative investing.

Like all technologies, Quantamental investing has its own merits and demerits. It might change the future of financial investments in an extremely positive direction – where true value is equal to market value, or in the direction of disasters – more incidents like the flash crash. Moreover, like every other technology, it is upon humans to see what can be done using these investing methods. Nevertheless, before that, we should not be clouded by the ego of what can and cannot be done so that we forget to see what should and should not be done.

This has been a guide to what Quantamental Investing is and its definition. Here we discuss the types of quantamental investing along with examples, advantages, and disadvantages. You can learn more about financing from the following articles –

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