Sunday, January 02, 2011

Quant, Fundamental or Technical?

Several approaches for generating alpha have been proposed and practiced by investment professionals in equity investment. A book I have been reading has confronted the age-old debate between the proponents of fundamental analysis and technical analysis, and has in fact added a third dimension - quantitative analysis. A very well informed and thought provoking set of ideas I must say!

As per the author, the three approaches focus on three different characteristics of the stock market. The fundamental analysis has depth but is narrow in its coverage, it relies on the ability of human brain to process diverse set of qualitative and quantitative factors simulatenously while still accounting for the effect of the general economic context on stock market performance. The technical analysis relies on the behavioral interplay amongst market participants - reflected in the price movement of various stocks and indices. It has the brevity of parameters - i.e. just the price of the stock over time - and can claim to deal with what ultimately matters - the demand for and supply of each stock in the market, as indicated by the price movement. The quantitative analysis is entirely backward looking, highly scientific and thus replicable and has the advantage of breadth. It can claim to look at the widest set of opportunities since it is not limited by the bandwidth of any one human being.

Is there a winner? I guess not. Investors have made and lost money while investing with each of the three approaches on a standalone basis. Each has some flaws and some advantages.

Fundamental analysis is intellectually appealing at the surface. It directly asks the question - what is the value of a stock and how does it compare with its price. However, as one delves deeper, one realizes that the estimate of value of the stock is as good as the assumptions made in arriving at it. The model can be tweaked in so many different ways to arrive at a given 'value' that the error term in estimation is often larger than the supposed gap between the 'value' and the 'price'.
Technical analysis captures the moods of the decision makers quite accurately. One can claim that whatever be the value of a stock, if the market participants agree on a different level for the price of that stock and stay there, one can never make money using the concept of value. The only way out is to let the story play out over a number of years through which the dividends paid by the company actually make up for the price paid for it as per the value model! That can be over 10 years in most cases. The problem with technical analysis however is that it is oblivious to the factors causing the prices to move. Analysing the chart of any stock price movement can never help one predict an improvement in its margins owing to say a regulatory change. The technical analyst will often be the last one to join the party in case of shifts in valuation driven by factors like this. Technical analysis then works only in still waters - not a good limitation when one is looking to generate market beating returns.

Quantitative analysis is too generic a term to be evaluated as a single strategy. However, if one assumes that a mathematical model based on historical data and analysis is used to predict the attractiveness of stocks or points of entry into the markets, the limitations of quant strategies become clear. In a manner similar to the technical strategies, quant strategies cannot account for the shifts in valuation. They also suffer from overgeneralization of certain trends. The benefit of quant strategies however lies in their ability to beat the market in terms of returns. In this respect they are better than fundamental or technical strategies which are in some sense trying to generate high positive returns. Their focus is typically not as much to beat the market as it is to generate good returns. When one restricts the mandate to beating the markets, one can start seeing the advantages of the quantitative strategies. Ultimately, as I have argued in another post ("Index Investing and Quantitative Strategies") on this blog, market returns as reflected in the performance of an index, are a special case of an oversimplified quant strategy. If one were to take some identifiers of good stock market performance from both technical and fundamental analysis, one can hope to beat the markets more consistently than either of the other two strategies.

One can almost go back to the Hegelian dialectic of thesis, antithesis and synthesis in the above debate. The thesis is 'fundamental analysis'. The anti-thesis is 'technical and quantitative analysis'. The synthesis then is a integrated approach which combines best of all the three! Something I have started working on thesedays.