Before the dotcom bubble, academic finance was slow to acknowledge the link between investors’ behavioural biases and financial markets. However, the field of behavioural finance is now well established and identifies two main areas of significance concerning systematic investing. First, there is a substantial body of evidence showing how difficult it is for non-systematic fund managers to make consistently reliable forecasts and decisions about investment risk allocation.
Second, there is an acknowledgment of these psychological biases’ effect on financial markets and the consequent opportunities for systematic investors in global markets. This can be evidenced by the fact that humans are risk-seeking when it comes to the opportunity to make very large profits (lotteries) and generally avoid the small probability of very large losses (insurance products). Furthermore, individuals will rely on relatively little historical information to make predictions with high confidence (the law of small numbers). They will tend to be overconfident about their forecasting abilities and are generally overly optimistic. These same behavioural biases are typical of non-systematic investment processes.
Apart from being unbiased, a systematic investment approach offers additional key advantages in terms of implementation, particularly when operated at scale and across global markets. Systematic fund managers can trade globally, across developed and emerging markets in assets on multiple exchanges around the world, and this can be achieved with very small investment teams. On a trading day, trading begins in Asia-Pacific markets, then European and African markets, before ending in American markets. Since all the decision making and investment processes are systematic, processing new information, assessing signals, monitoring risks and executing trades is fast and can be implemented continuously. This represents a real challenge for fund managers who do not invest systematically and according to a consistent and repeatable methodology.
For non-systematic fund managers, analysing and monitoring a vast number of assets and markets is almost impossible without a very large team of analysts. Adding additional analysts makes it challenging to ensure the consistent implementation of views and significantly increases overheads, inconsistencies, and costs ultimately passed on to investors. This scalability of markets traded and objective, repeatable processes increase the potential diversification in systematically managed offshore portfolios. The execution of an offshore systematic investment approach also allows for innovation in disciplined risk management, which can be built directly into the process rather than applied as an afterthought.
In addition to relying on scientific methods to generate an investment signal, a systematic approach allows limits to be set and monitored to control risks and exposures. These could include limits to volatility, exposure to particular markets or geographies, risk-adjusted returns and marginal contributions to risk at the asset, asset class and portfolio level. Once these limits are reached, position sizes can be automatically adjusted based on predefined rules.
Systematic investing is premised on the belief that market prices are not random but instead exhibit persistent, measurable and predictable behaviour and idiosyncrasies. Applying these processes offshore across developed and emerging markets improves diversification and reduces concentration risk. Global systematic investing can be operated by a very small research-driven team with financial and data science skills. This combination of size, skills and agility offers the flexibility to reject or validate statistically testable investment ideas fast systematically.
To succeed as an offshore systematic fund manager, it is important to have an extremely high-quality proprietary database of financial data and the analytics platform to test and validate investment processes. Typically, initial testing and development are conducted on a historical dataset sample, excluding some markets and periods. If the hypothesis is not rejected during initial testing, the test is repeated using the markets and historical periods that had been kept out of the sample. This multi-stage approach minimises data mining pitfalls and cherry-picking geographies and specific periods.
The next step in the research process is to investigate the sensitivity of the results to assumptions. Alternative methods of testing the hypothesis are also specified, which validates all research findings and ensures that each new strategy fits well into the overall investment portfolio.
Finally, it is possible to monitor and test the enhancements in a non-live environment to assess real-world impact and performance before implementing in a live portfolio. This meticulous scientific method is in stark contrast to the ad hoc approach of a typical non-systematic fund manager.
There is emerging scientific literature comparing the performance of systematic versus non-systematic investing styles. The evidence so far shows that systematic fund managers appear to generate higher performance and are superior to non-systematic fund managers, particularly when investing across a global universe of assets. This finding supports our earlier view around the advantages of scalability and trading across various geographies and exchanges offered by a systematic investment process operated at scale.
Clients are becoming more aware of the broader benefits of a systematic investment approach applied across global markets. This bodes well for the future of the investment industry. By investing with systematic fund managers with global reach, clients can harness the advantages of a scientific approach to investment management. They should be well placed to face the uncertainty inherent in investing in financial markets. BM
This article was written by Mario Fisher, Head of Equities | Chief Data Scientist at Prescient Investment Management
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