As readers would know, discussing ways to combine quant and fundamental investing has been a topic I care about (see some prior posts here, here and here).
Perhaps I’m biased. But I believe that proper collaboration between quant and fundamental approaches is still a largely unexplored area. Yes, many fundamental shops rely on quant screens and many quant shops rely on fundamental justifications for their factors but often these approaches lack depth, balance and synergy. The primary style ends up driving the entire process, with the secondary style contributing very little outside the ‘marketing story’.
The Problem - Patterns vs Change
One reason why combining quant and fundamental investing is so hard is because quantitative analysis focuses on finding repeatable patterns while fundamental analysis focuses on identifying unique changes. On the surface, the two styles are looking for the exactly opposite insight.
Even when a quant uses a fundamental idea like profitability and even if she measures its change instead of level - she is still trying to find a set of repeatable characteristics, patterns that on average lead to positive returns. Compare that to a fundamental analyst who might see that same improvement in profitability as a temporary over-hyped event for one company and an early sign of longer than expected sustainable growth for another.
A typical conversation between a quant and a fundamental analyst can be frustrating to both sides.
While the quant is waiting to hear insights that are akin to equations - something she can program and backtest on the past data - the fundamental analyst is trying to explain that he looks for unique aspects that are about to change which is unappreciated by the market.
While the fundamental analyst is waiting to see a list of outperforming stocks - the quant is trying to explain that the stock-level hit rate of any quant model is slightly over 50%, making individual stock picking from that ‘outperforming’ list a coin-toss.
A Solution - Great Questions
Among many possible ways to improve quantamental investing, one concept that I have experienced personally has been the power of great questions.
Questions take the conversation one level higher - out of the ‘what and how to measure’ to the ‘why measure anything’ in the first place.
At the level of great questions - quants and fundamental analysts can get along very well and have a conversation full of insights. Then each can go back to their methods and figure out the ‘what’ and the ‘how’ to measure in order to answer those questions.