Islamic Investor Focus - Quantitative Investment Process

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Traditional active management of funds can be susceptible to cognitive biases, argues Ian Lancaster, who advocates the use of quatitative techniques to manage Shariah compliant portfolios.

Transcript of Islamic Investor Focus - Quantitative Investment Process

  • 1. ISLAMIC INVESTORFEATUREQuantifying global Islamic equities: Howquantitative techniques can be used to manageShariah compliant portfoliosTraditional active management of funds can be susceptible to cognitive biases, argues Ian Lancaster, whoadvocates the use of quatitative techniques to manage Shariah compliant portfolios.If you were asked to describe ato analysts forecasts and measures of all companies in the investment universequantitative investor you might well management eciency such as return onat the same time. Since most work isimagine a mathematical whizz, hidden equity (ROE). However, despite havingcomputer-based, processing times areaway from investors, surrounded by a common goal and using similar tools, also faster, meaning that a quantitativehigh tech computers and blackboardsthere are a number of key dierences thatstrategy is far less constrained withscrawled with arcane statistical distinguish how the two approaches are respect to potentially protableformulae. Whilst such individuals no implemented in practice. opportunities than a traditional managerdoubt exist, on average you would bewould be.rather far from the mark.Most quantitative investors merely seek By their Quantitative techniques are thereforeparticularly well suited for investorsto implement investment processes thatare easily understandable to traditional very nature, dealing with Shariah benchmarks, giventhat the nancial screening criteriainvestors, albeit relying more heavily onnumerical techniques. Indeed, without quantitative used to create them will alter the set ofinvestable companies every time theknowing it, Islamic investors are alreadymuch closer to the world of quantitative portfolios offer a index is recalculated.investment management than they mightrealize. number of desirableIts not just a question of how muchinformation investors are capable ofThe process of assessing Shariah attributes thatprocessing, however. Equally importantis the way in which they process it. Wecompliance itself makes extensive use of should appeal to all are all unfortunately prone to whatquantitative techniques. Given the scalepsychologists refer to as cognitiveof the task, it could hardly be otherwise. investors: specificallybiases: habits of processing informationThe Standard & Poors Broad Marketthat can lead to systematic errors inIndex (BMI) contains over 11,000 stocks, transparency,decision making. consistency,each of which must be regularly assessedin terms of a range of nancial criteria to Whilst often useful and a convenient repeatability andgauge their suitability for inclusion in theway of saving time, the everyday mentalIslamic Indices.shortcuts that lead us to make cognitive risk controlerrors are particularly dangerous forFinancial assessment via accounting-investors. Whether simply following thebased screens can be conducted across crowd into hot stocks and overlookinga large universe with comparative ease, out-of-favor issues, or overestimatingallowing Shariah scholars to quickly Traditional investment management is your ability to forecast correctly simplyidentify those companies that operatebased upon the in-depth examinationbecause you were right the previouswith excessive debt levels and/or high of a companys strategic positioning,time, cognitive biases can have a materialcash holdings. management strength and competitiveimpact on investment performance. threats. The valuation of a companysMoreover, all market participantsequity can also be a complex and timeTraditional active management reliesultimately seek the same outcome.consuming business, as anyone whoheavily on the subjective judgmentsRegardless of whether they are has assembled a detailed set of nancial of individual analysts and managers,quantitative in nature or choose toforecasts and a discounted cash owmaking it susceptible to cognitive biases.adopt a more traditional fundamental model will attest. The time and resourcesA quantitative investor, however, willapproach, the goal of all investors is torequired to conduct fundamentalcreate and most importantly adhere to aachieve superior investment returns at research therefore limits the opportunityrobust set of investment rules; a processlower levels of risk.set available to traditional investors, in which signicantly reduces the scope for addition to constraining the speed withcognitive errors.Quantitative investors use many of the which they can react to new information.same tools that would be familiar toMoreover, quantitative strategies can betheir traditional counterparts, such as theQuantitative analysis, by contrast, is designed specically to exploit certainprice to earnings ratio (PER), revisions capable of dealing with information for Continued277th September 2011

2. ISLAMIC INVESTOR FEATUREContinuedcognitive biases strategies that focus onextremely volatile market conditions. approach can be used to understand, formomentum, for example, are based onThis represents a validation of our example, whether PER is a useful metricthe statistically demonstrated observation underlying investment strategy, but alsoin any given sector, or whether value asthat investors often under-react to newserves to illustrate an important feature a style is currently more relevant for ainformation. A company that releases of quantitative strategies in general:particular sector than momentum. Thegood news may therefore see its sharenamely, that they tend to produce cognition process undertakes similarprice outperform the market over the much better risk-adjusted returns thanfactor analysis across a universe ofnext weeks, or even months. Equally, traditional fund strategies, because they around 2,500 Shariah compliant stocksbad newsow may be followed by a longare capable of targeting very specic globally to try to understand whichperiod of under-performance. sources of excess return - in our casevariables are most important, and more style trends - and at the same time importantly, which characteristicsBy their very nature, quantitative rigorously reduce unwanted risks from are most likely to lead to share priceportfolios oer a number of desirablethe portfolio.outperformance in the future.attributes that should appeal to all Quantitativeinvestors: specically transparency, In terms of style relevance, where andconsistency, repeatability and riskwhen are also of critical importance. strategiescontrol. These attributes are of criticalDierent geographic regions mayimportance for investors wishing toexperience very dierent macroeconomic represent theunderstand how their portfolio manager conditions at the same point in time is seeking to beat the market and, justone need look no further for comparisonsas importantly, how the actual returnswere generated. Portfolios managed efforts of ordinary than the dynamic growth economies of Asia and the debt-laden economies ofusing quantitative techniques are bettersuited to fullling such requirementsinvestors toEurope and the US.since the models driving them areclearly expressed as a set of transparentimplement their Moreover, these relationships will undergo constant change, as economicinvestment rules, consistent anddemonstrably repeatable via simulatedinvestment ideas in conditions evolve over time. It is therefore advantageous for a quantitativeback tests and easier to manage in termsof risk through statistical optimization. a more disciplinedstrategy to analyze dierent regions and sectors separately, in addition toIf good performance is to be repeated inthe future, visibility over these factors is manner usingretaining the ability to change over time as the economic cycle unfolds.vital. standard statisticalThe investment process outlinedThe investment team at Reliance AssetManagement (Malaysia) have been techniqueshere could, of course, be applied to any investment universe, providedsuccessfully running Shariah compliant sucient data is available to perform theportfolios for a number of years now. Thesupporting factor analysis.WSF Reliance Global Shariah Growth Our approach to beating the marketFund was launched in August 2010. Theinvolves understanding which typesWe can all learn to be better investors.fund selects investments from the S&Pof company oer the most compelling Human insight and intuition can, inDeveloped BMI Shariah index using thecombinations of investment styles, such our view, be substantially enhancedproprietary cognition stock selectionas value, growth, or momentum. It iswithin a framework of statistical checksmodel. important that these denitions reectand balances that help to oset our economic reality. tendencies towards impatience andThis is a computer-based expert system irrationality. Quantitative strategieswhich observes, and makes decisionsFor example, a sector analyst coveringrepresent the eorts of ordinarybased on, most of the indicators thatthe biotechnology or telecommunicationinvestors to implement their investmenttraditional investors would analyze, sectors might consider the PER aideas in a more disciplined mannerbut in a systematic, data-intensive wayrelatively useless valuation metric, sinceusing standard statistical techniques. i.e. using a quantitative approach.protability amongst the companiesFar from being a mathematicallyCognition attempts to be unwaveringlythey cover would likely be held back by incomprehensible conception, now thatrational and risk-controlled ininvestment in research and developmentdata and computing power is universallyundertaking the process that it uses toor new subscriber acquisition.available, we would argue that everyoneformulate a portfolio of global ShariahFortunately, we dont need an army of should attempt to bring quantitativecompliant equities.analysts to tell us which factors to use in insights into their investment approach. every sector around the world.And Shariah compliant investors haveTo date the strategy has producedalways been quants in any case!encouraging levels of excess return. Correlation (factor) analysis, whichHowever, and more importantly in our quanties the nature of the relationshipIan Lancaster is CEO of Reliance Assetview, the volatility of those excess returns between two variables, oers a powerful Management Malaysia. He can be contactedhas also been relatively low, despitetool for answering such questions. This at [email protected] September 2011