australiaen
Simplistic factor models may get arbitraged out of existence

Simplistic factor models may get arbitraged out of existence

26-02-2020 | Interview

Which financial innovations will investors remember 20 years from now? Will quant investing continue to thrive? Here are some of the topics we discussed with Jim O’Shaughnessy.

  • Yann Morell Y Alcover
    Yann
    Morell Y Alcover
    Investment Writer

Speed read

  • New tools that allow for customization are transforming the fund industry
  • Arbitraging human behavior is the last sustainable factor
  • Well-designed strategies based on conventional factors will keep working

Jim O’Shaughnessy is the Chairman and Co-Chief Investment Officer of O’Shaughnessy Asset Management (OSAM), and acclaimed author of the best-selling book What Works on Wall Street. We talked with him about the major trends currently shaping the fund industry, the next generation of quantitative investment products and the future of factor strategies.

Jim O'Shaughnessy

You have witnessed firsthand many of the changes that have been shaping financial markets and the investment industry over the past two to three decades. Which of these changes do you think has had the most impact?

“I think the change with the most lasting impact in financial markets is their democratization. Technology is eating markets just like it's eating everything else. And what you're seeing – at least here, in the US – with the conversion of all brokers to no-commissions trading, and apps like ‘Robin Hood’ or OSAM’s recently launched ‘Canvas’, which allows for customization, is really transformative.”

“When we’ll look back, 20 years from now, we won't be talking as much about things like central bank policy or the macroeconomic situation. What we’ll see is that the way people invest – and by people I mean everyone –radically changed. Markets have stopped being just for the elites and technology are giving average investors tools that are really remarkable.”

What are the implications from a product offering perspective?

“I think the implications are that you're going to see a trend away from packaged products. First, it's going to be small amounts, but then you're going to start seeing some kind of a snowball effect. I think people are going to embrace these things because, for the first time really in history, they will be able to reflect their own values in their investments.”

Do you mean that individuals will not necessarily have to pick one standard product anymore, that they'll be able to choose among different options just like you customize a car, for instance?

“Yes, exactly. That's in fact a really good analogy: the way that we now are able to pick a car online. Off comes the car, and then you get to pick the color, you get to pick the interior, you get to pick the options. And as you're doing that, the car you’re looking at online changes, right? It changes to the color you want, to the interior you want, to the additional packages you want or don't want.”

“I think we're going to see very similar things happening in portfolio creation. We work with financial advisors and that's where you'll see the changes first. But, ultimately, this is going to get pushed down to the individual investor. Financial advisors will really be able to offer specific and customized portfolios to their clients.”

Now also follow us on Instagram
Now also follow us on Instagram
Follow

All this seems to be calling for huge investments from asset managers, to be able to offer this kind of really tailored offering to individual investors, right?

“At OSAM we've already launched an app, which we consider the first investment portfolio operating system, if you will. We call it Canvas and it stems from our devotion and passion around technology and our dissatisfaction with off-the-shelf technology. So, we ended up building all of our own system.”

“Now, do I think that other asset managers will have to develop similar technologies? Absolutely. It's one of those things where when there's one, there's going to be more than one. And if you're just going to sit on your laurels and say, that is the way we do it at company X, Y or Z, you know who’s going to be victim of creative destruction. That's the way the world has always worked.”

So, in a way, it's like the next generation of quant, right? It started with the automation of the investment process and now we’re talking about automating the creation of custom strategies.

“Exactly. We pride ourselves of being very open-minded. We kind of sit around and say, well, what do we want? What kind of capabilities would we want? And of course we ended up building those at OSAM. But then we thought, well gosh, if we want them, maybe there's a whole lot of other people out there who them want too. And that's what we're finding.”

“I mean the launch of Canvas was only a few months ago. And the interest level is far beyond our most optimistic forecast. So, in recent years we had the Reaper come for basis points in asset management and, now, the Reaper is going to come for fees in advisory business as well, unless they can prove and demonstrate they are able to build a better mousetrap for clients.”

We've been talking a lot about the future, but let's get back to the present. Do you think all these changes that we've been mentioning somehow make the current popular quant strategies obsolete?

“I think that simplistic single factor models may get arbitraged out of existence. But more sophisticated models, with multiple factors, will continue to work, not so much because they’ve achieved great performance in the past but mainly because of what they tell [us] about our behavior as investors. Arbitraging human behavior is the last sustainable factor.

“Take my book What Works on Wall Street, which has been out for 20 years. The factor models I describe in it, yes, they have their downs, of course they do, but they also have great sustainable long-term performance. And I think that's less to do with how brilliant the factors are and much more to do with our understanding about the way human investors are going to react.”

Humans continue to consistently react the same way. And it's usually wrong

“Quite simply, humans continue to consistently react the same way. And it's usually wrong. So, as long as we humans don't evolve rapidly, I think that well-designed rules-based investment strategies based on conventional factors will continue to work.”

Just to wrap up, when do you plan to publish the next edition of What Works on Wall Street?

“The last edition of the book was published 10 years ago and what we're trying to decide now is how best to update the information it contains. We are currently toying with a bunch of different ways. So we're not sure yet how that's going to happen. It will happen. But we're still looking at the most efficient way to get it to the largest number of people.”

Subjects related to this article are:
Logo

Disclaimer

BY CLICKING ON “I AGREE”, I DECLARE I AM A WHOLESALE CLIENT AS DEFINED IN THE CORPORATIONS ACT 2001.

What is a Wholesale Client?
A person or entity is a “wholesale client” if they satisfy the requirements of section 761G of the Corporations Act.
This commonly includes a person or entity:

  • who holds an Australian Financial Services License
  • who has or controls at least $10 million (and may include funds held by an associate or under a trust that the person manages)
  • that is a body regulated by APRA other than a trustee of:
    (i) a superannuation fund;
    (ii) an approved deposit fund;
    (iii) a pooled superannuation trust; or
    (iv) a public sector superannuation scheme.
    within the meaning of the Superannuation Industry (Supervision) Act 1993
  • that is a body registered under the Financial Corporations Act 1974.
  • that is a trustee of:
    (i) a superannuation fund; or
    (ii) an approved deposit fund; or
    (iii) a pooled superannuation trust; or
    (iv) a public sector superannuation scheme
    within the meaning of the Superannuation Industry (Supervision) Act 1993 and the fund, trust or scheme has net assets of at least $10 million.
  • that is a listed entity or a related body corporate of a listed entity
  • that is an exempt public authority
  • that is a body corporate, or an unincorporated body, that:
    (i) carries on a business of investment in financial products, interests in land or other investments; and
    (ii) for those purposes, invests funds received (directly or indirectly) following an offer or invitation to the public, within the meaning of section 82 of the Corporations Act 2001, the terms of which provided for the funds subscribed to be invested for those purposes.
  • that is a foreign entity which, if established or incorporated in Australia, would be covered by one of the preceding paragraphs.
I Disagree