“Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day. But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day.”
That is how Adam Smith described the power of the division of labor on the first page of his seminal inquiry into The Wealth of Nations. Efficiencies can be gained by utilizing specialized hands and breaking up the shared work of “production” into small tasks—and not only in 18th-century pin factories.
In the world of modern investing, recent years have seen a proliferation of large and alternative data sets and great leaps in computing power, but systematic investing continues to require analysts to provide context and distinguish true investment signals from noise. Combining the diverse perspectives of fundamental analysts and “quants” can create powerful benefits due to what we see as their complementary nature.
Bridging the Gap
The following table summarizes some of the pros and cons of each investment analysis approach.
Fundamental vs. Quantitative Investing
|Single name security selection drives alpha||Asset allocation using factors drives alpha|
Source: Neuberger Berman
There have been numerous attempts to get the best of both worlds by bridging the gap between fundamental and quantitative investment analysis. Many attempts have been unsuccessful, as they either simply lump quant and fundamental strategies together in a fund of funds or try to aggregate different stock rankings from quant and fundamental processes. Neither of these approaches takes account of potential differences between these processes—of time horizon, incentives or other factors.
A less common but potentially more successful approach is to create an integrated team of fundamental and quantitative analysts operating within the same incentive and operating structure.
It can be difficult and costly to build a sizable team of experienced quant and fundamental professionals, not to mention fostering the collaborative culture necessary to make it work well. But this approach can create feedback loops between the two capabilities that can genuinely enhance them both.
Talking It Through
Cross-sectional quantitative analysis and big data integration can help fundamental analysts develop a more holistic view of the environment around the stocks they cover. Sophisticated cleaning and analysis of credit card transactions, web searches, job postings and other alternative datasets can be used to corroborate or indeed challenge a fundamental investment thesis. And introducing a quant culture across a firm’s analytical platform can bring further systematization to decision making and help to limit undetected behavioral biases.
In the other direction, fundamental analysts can contribute a deep understanding of the key drivers of return and risk in the individual stocks and sectors they cover to the quants process. The raw datasets we work with on the Breton Hill team can often benefit from improvements based on context from our colleagues at Neuberger Berman on the fundamentals team, perhaps regarding idiosyncratic events or corporate reporting methodologies. When we develop and evaluate sector-specific signals, the insights we get from sector specialists are invaluable. These enhancements can support higher conviction quantitative portfolios, capturing idiosyncratic opportunities that quants would typically diversify away.
A difference of opinion about a cruise-line stock that arose internally provides a good example of this integrated approach in action. This stock scored poorly across a variety of quantitative metrics but its fundamental analyst rated it a buy. When we got together to discuss it, it became clear that the main fundamental investment thesis centered on tailwinds for the cruise-line industry as a whole, such as a broad increase in onboard spending. In the end, we expressed that thesis with a different cruise-line security that had stronger quantitative characteristics.
Without noticing the difference of opinion and talking it through, the quants team might have missed a cruise industry opportunity and the fundamental analysts might have picked the wrong stock for that opportunity. That example shows how different the integrated approach is from a different type of “quantamental” approach that seeks out stocks with both quant and fundamental buy ratings.
Towards a Common Aim
Obtaining consistent and robust pure “alpha” is becoming more and more difficult as markets get more saturated and information spreads more broadly and more quickly than ever. Asset owners are responding by increasingly allocating to passive rather than active investment strategies.
Ultimately, however, these trends could create opportunities for those willing to invest in cutting-edge techniques and technology, new data sources and the collaborative culture that can genuinely integrate these new tools with traditional approaches to analyzing, selecting and building informationally-rich portfolios of stocks.
As Adam Smith observed, great things can happen when specialists collaborate toward a common aim. That’s why we believe the future of investing integrates the discipline and scalability of quant investing, the deep contextual insight of fundamental analysis and the innovations of data science into one cohesive package.