Good Science

Professors In, Professionals Out
Sam Lee's excellent article from last week, "The Science of Investing," describes the triumph of scientific, or quantitative, investing. (This article treats the terms "quantitative" and "scientific" as synonyms, in each case referring to investment selections that are done solely on the numbers as opposed to attempting to evaluate a company's prospects, its industry, and the quality of its management.) Most new stock-fund sales are into funds that are constructed by science rather than ones that rely on the art of a portfolio manager--among them nearly all exchange-traded funds and index mutual funds.

As Sam points out, this science comes courtesy of the academic community, not the investment community. Not only was the concept of the index fund developed within academia, but so too was the formalization and scoring of the factors Sam describes, such as value, size, and liquidity. These factors are now used to chip away at the claims of traditional fund managers by attributing what once was regarded as manager brilliance to the mere presence of factors. In a real sense, finance professors have marginalized traditional fund managers.

Which means the academic community accomplished what the practitioners could not. Within the investment industry, would-be scientists had long attempted to knock traditional managers off their perch, with little success.

There were essentially no quantitative investors two generations ago. Purchasing stocks solely on the numbers was regarded as peculiar at best and breaching fiduciary duty at worst. (Two notable exceptions to the rule were Ben Graham and John Maynard Keynes, each of whom bought baskets of stocks that sold on the cheap without bothering to research the individual companies.)

This didn't change much until the 1960s, when early computers permitted the storage and manipulation of databases. In particular, investors could test strategies based on stocks' historic prices, thereby putting the centuries-old dark art into more of a scientific framework. The technical analysis data could be used either to trade individual stocks or to devise market-timing systems that would move the whole portfolio.

Over the next 20 years, technical analysis failed its field test and faded into obscurity. Replacing it were stock-scoring systems that took advantage of the day's much-increased computing power to conduct hundreds or even thousands of calculations on thousands of different stocks. These programs differed from their technical predecessors in their complexity and in emphasizing fundamental items such as earnings and price ratios.

This version of financial science fared well for a while, attracting the "smart money" of several major institutional investors. For retail investors, Vanguard sponsored two quantitative funds managed by Batterymarch, a Boston-based company, and Fidelity launched its Disciplined Equity Fund, which used a neural network to evaluate daily data in what was billed as an exercise in "artificial intelligence." Ultimately, Fidelity's fund as well as most of the complex stock-scoring programs lost to natural intelligence, as they lagged not only the indexes but also most actively managed funds.

The 1990s featured another form of quantitative investment that was even less reputable than the stock-scoring models. In fact, most managers wouldn't admit to using the strategy. This was the practice of "flipping" the stock of an initial public offering by purchasing shares at the initial launch price, then very quickly selling that IPO at a higher price to retail buyers. This tactic, quite clearly, had very little to do with managerial brilliance and a whole lot to do with institutional access. It was also temporary; when the IPO boom dried up during the 2000-02 technology-stock slump, so did the gains from flipping.

Flipping hot stocks was something of the last gasp for the practitioners. Since then, nearly all assets in quantitatively managed funds have gone into index or factor funds that had roots in academia.

That the academic scientists won the battle, and not the investment-professional scientists, is a profound benefit for retail fund investors. To start, professors share information. (For my article last week on the Shiller ratio, I downloaded the data for the chart from Dr. Shiller's website. Similarly, Ken French maintains a website that permits visitors download the raw Fama-French data and conduct their own calculations.) In contrast, the professionals disclosed only as much as was necessary. Institutional investors might perhaps learn more using their clout. The lowly retail buyer? Not a chance.

Free information leads to funds that sell at a low price. Quantitative professionals who have a secret expect to be compensated handsomely. An insight discovered through technology that others have not discovered can be priced as the market will bear. (Case in point: hedge funds.) Academically derived portfolios, on the other hand, come from publicly available data and are relatively cheap. Expense ratios on factor funds are usually 0.50% per year or less. Market index funds, of course, charge even less.

The combination of open information and low cost is a major benefit for the retail investor. Open information means there is not a limited supply of the best investment material, available only to institutions or wealthy, exclusive individuals. Open information means the individual investor has the same opportunity as the largest institutional buyer. And low cost means that even if the retail investor does not get quite the same deal as the institutional buyer, it's still a fairly modest charge in absolute terms.

In short, while this might not be the best of all possible worlds, it's the better of the two possible investment worlds. Investors would not have been well-served had the investment scientists triumphed. In such a case, the new boss would have looked like the old boss: claims of superiority, hidden investment security, and high fund expense ratios.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.