Home > Articles > Business & Management > Finance & Investing

Overview of Quantitative Investing

In this excerpt from his book, Principles of Quantitative Equity Investing: A Complete Guide to Creating, Evaluating, and Implementing Trading Strategies, Sugata Ray gives an overview of quantitative investing, including a discussion of screens, backtesting, and implementation.
This chapter is from the book

Quantitative investing is generally defined as the use of a rigorous set of rules based on easily observable criteria to guide investment decisions. It encompasses a wide variety of strategies, from longer-term equity strategies where equities are bought and held for periods up to or longer than a year, to very short-term strategies trading in and out of securities multiple times during the course of a day. Of course, these shorter-term strategies do not really “invest” in the securities. Regardless of the exact type of strategy employed, there are several common steps in all types of quantitative investing: (1) screens, (2) backtests, and (3) implementation. This general process is graphically represented in Figure 1.1.

Figure 1.1

Figure 1.1 Life cycle of a quant investment

Screens

A screen is a formula for deciding what to buy and sell at any given time. A simple screen might be: Buy all stocks that have positive returns over the last year.1 This is an example of a stock screen, which divides the universe of stocks into those the system will pick to buy and those it will not. A more complicated stock screen could have multiple criteria, such as “buy all stocks that have positive returns over the last year AND price to earnings (PE) ratios between 5 and 15.”

As opposed to stock screens, you can also implement timing screens. Timing screens are screens that use some measure of the overall economy to decide whether it is a good time to buy or sell. An example of a timing screen could be “Move all assets to SPY if unemployment has fallen two months in a row. Otherwise, keep all assets in cash.” SPY is the ticker for a security that mirrors the S&P 500 index. Thus, the screen basically keeps money in the broad equity markets if the economy is stable and in cash if unemployment is rising.

The difference between timing screens and stock screens can be subtle, and a number of screens will have flavors of both types. “Buy all stocks if unemployment has fallen two months in a row, and buy only stocks with PE ratios between 5 and 15 if not” is a screen that combines timing and stock screen elements. This book generally keeps them separate, but it is important to remember that they could be used together, if desired.

A screen generally returns a list of stocks and then a decision must be made. For example, the screen “Buy all tech stocks with PE ratios less than 10 that are profitable and pay a dividend” might return a list of about 15 stocks. The next step is to decide what to do with these lists. Generally, the easiest (and most popular) strategy among quantitative investors is to invest capital equally in all stocks that pass through a screen. So if 15 stocks pass through the screen, you divide the money you are investing equally into the 15 stocks and that will be your portfolio. There are other ways to weight the list: For example, you can weight by market capitalization or by dividends. Alternatively, you could do deeper fundamental analysis on the company names generated by the screen and pick individual securities to invest in, rather than simply dividing your capital equally among the companies that pass through the screens.

You should feel free to use screens to support deeper analysis of individual companies. Chapter 4, “For the Deeper Divers among Us: How to Use Quantitative Strategies to Enhance Fundamental Valuations,” explores two case studies that do just that. However, this book does not cover techniques to do deep analysis into individual companies.2

Horizons (or Rebalancing Frequency)

A key part of any quantitative investing screen is the horizon of the strategy. If the screen provides information that determines what the trade will be, the horizon provides the duration over which the information in the screen is valid. After the horizon is reached, the old positions are closed out, and if desired, the screen can be run again and new positions chosen. This process of closing out old positions and choosing new ones is known as rebalancing. The horizon of your strategy is, thus, also known as the rebalancing period. Rebalancing is a very important part of quantitative investing and Chapter 8, “Rebalancing—Why, How, and How Often,” is dedicated to this concept.

Many times, the measures used in the screen dictate the horizon. So, for example, in the screen discussed earlier that was based on unemployment, the strategy must have a horizon of at least one month because unemployment numbers are released monthly. Put a different way, horizons cannot be shorter than the frequency at which information is released (if they were, the stocks in the screen would remain the same until new information came out). The screens based on PE ratios can have a much shorter horizon because the price of a stock is constantly changing and, thus, PE ratios are constantly changing.

If the trading horizon is longer than the information frequency, you risk that the information previously used to generate the portfolio has gone stale in between rebalances. For example, you sort on PE ratios today and buy all stocks with PE between 0 and 10. Tomorrow, one of the stocks you bought spikes, its PE is more than 10 and no longer passes through your screen. If your horizon is longer than a day, you will hold this stock despite the fact that the stock no longer passes through your screen. Thus, the shorter the horizon, the less likely stocks that are in your portfolio that do not pass through your screen, and the less likely that your portfolio excludes stocks that have evolved to pass through your screen.

The other main factor driving strategy horizon is transaction costs. The shorter the horizon of your strategy, the more times you will have to trade out of old positions and into new ones. Trading generally incurs transactions costs, both in terms of commissions, price impact when trading, and time and headache spent executing your trades.

This is the main tension in choosing the ideal strategy horizon. Too long and you’re holding stocks based on old information; too short and your returns are being eroded by transaction costs. In the financial industry, trading horizons can range from the extremely long (a year or even longer) to the very, very short (microseconds or even nanoseconds). High-frequency trading is the form of quantitative “investing” that deals with these very short holding periods. However, high-frequency trading really is not “investing” because positions are rarely held overnight and rarely is the intention of such trades to actually invest in companies. This book, for most strategies, runs a quarterly rebalance. Equities Lab (the tool that most of the analysis in this book uses) has a default rebalancing period of a week, although that can be easily changed.

InformIT Promotional Mailings & Special Offers

I would like to receive exclusive offers and hear about products from InformIT and its family of brands. I can unsubscribe at any time.

Overview


Pearson Education, Inc., 221 River Street, Hoboken, New Jersey 07030, (Pearson) presents this site to provide information about products and services that can be purchased through this site.

This privacy notice provides an overview of our commitment to privacy and describes how we collect, protect, use and share personal information collected through this site. Please note that other Pearson websites and online products and services have their own separate privacy policies.

Collection and Use of Information


To conduct business and deliver products and services, Pearson collects and uses personal information in several ways in connection with this site, including:

Questions and Inquiries

For inquiries and questions, we collect the inquiry or question, together with name, contact details (email address, phone number and mailing address) and any other additional information voluntarily submitted to us through a Contact Us form or an email. We use this information to address the inquiry and respond to the question.

Online Store

For orders and purchases placed through our online store on this site, we collect order details, name, institution name and address (if applicable), email address, phone number, shipping and billing addresses, credit/debit card information, shipping options and any instructions. We use this information to complete transactions, fulfill orders, communicate with individuals placing orders or visiting the online store, and for related purposes.

Surveys

Pearson may offer opportunities to provide feedback or participate in surveys, including surveys evaluating Pearson products, services or sites. Participation is voluntary. Pearson collects information requested in the survey questions and uses the information to evaluate, support, maintain and improve products, services or sites, develop new products and services, conduct educational research and for other purposes specified in the survey.

Contests and Drawings

Occasionally, we may sponsor a contest or drawing. Participation is optional. Pearson collects name, contact information and other information specified on the entry form for the contest or drawing to conduct the contest or drawing. Pearson may collect additional personal information from the winners of a contest or drawing in order to award the prize and for tax reporting purposes, as required by law.

Newsletters

If you have elected to receive email newsletters or promotional mailings and special offers but want to unsubscribe, simply email information@informit.com.

Service Announcements

On rare occasions it is necessary to send out a strictly service related announcement. For instance, if our service is temporarily suspended for maintenance we might send users an email. Generally, users may not opt-out of these communications, though they can deactivate their account information. However, these communications are not promotional in nature.

Customer Service

We communicate with users on a regular basis to provide requested services and in regard to issues relating to their account we reply via email or phone in accordance with the users' wishes when a user submits their information through our Contact Us form.

Other Collection and Use of Information


Application and System Logs

Pearson automatically collects log data to help ensure the delivery, availability and security of this site. Log data may include technical information about how a user or visitor connected to this site, such as browser type, type of computer/device, operating system, internet service provider and IP address. We use this information for support purposes and to monitor the health of the site, identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents and appropriately scale computing resources.

Web Analytics

Pearson may use third party web trend analytical services, including Google Analytics, to collect visitor information, such as IP addresses, browser types, referring pages, pages visited and time spent on a particular site. While these analytical services collect and report information on an anonymous basis, they may use cookies to gather web trend information. The information gathered may enable Pearson (but not the third party web trend services) to link information with application and system log data. Pearson uses this information for system administration and to identify problems, improve service, detect unauthorized access and fraudulent activity, prevent and respond to security incidents, appropriately scale computing resources and otherwise support and deliver this site and its services.

Cookies and Related Technologies

This site uses cookies and similar technologies to personalize content, measure traffic patterns, control security, track use and access of information on this site, and provide interest-based messages and advertising. Users can manage and block the use of cookies through their browser. Disabling or blocking certain cookies may limit the functionality of this site.

Do Not Track

This site currently does not respond to Do Not Track signals.

Security


Pearson uses appropriate physical, administrative and technical security measures to protect personal information from unauthorized access, use and disclosure.

Children


This site is not directed to children under the age of 13.

Marketing


Pearson may send or direct marketing communications to users, provided that

  • Pearson will not use personal information collected or processed as a K-12 school service provider for the purpose of directed or targeted advertising.
  • Such marketing is consistent with applicable law and Pearson's legal obligations.
  • Pearson will not knowingly direct or send marketing communications to an individual who has expressed a preference not to receive marketing.
  • Where required by applicable law, express or implied consent to marketing exists and has not been withdrawn.

Pearson may provide personal information to a third party service provider on a restricted basis to provide marketing solely on behalf of Pearson or an affiliate or customer for whom Pearson is a service provider. Marketing preferences may be changed at any time.

Correcting/Updating Personal Information


If a user's personally identifiable information changes (such as your postal address or email address), we provide a way to correct or update that user's personal data provided to us. This can be done on the Account page. If a user no longer desires our service and desires to delete his or her account, please contact us at customer-service@informit.com and we will process the deletion of a user's account.

Choice/Opt-out


Users can always make an informed choice as to whether they should proceed with certain services offered by InformIT. If you choose to remove yourself from our mailing list(s) simply visit the following page and uncheck any communication you no longer want to receive: www.informit.com/u.aspx.

Sale of Personal Information


Pearson does not rent or sell personal information in exchange for any payment of money.

While Pearson does not sell personal information, as defined in Nevada law, Nevada residents may email a request for no sale of their personal information to NevadaDesignatedRequest@pearson.com.

Supplemental Privacy Statement for California Residents


California residents should read our Supplemental privacy statement for California residents in conjunction with this Privacy Notice. The Supplemental privacy statement for California residents explains Pearson's commitment to comply with California law and applies to personal information of California residents collected in connection with this site and the Services.

Sharing and Disclosure


Pearson may disclose personal information, as follows:

  • As required by law.
  • With the consent of the individual (or their parent, if the individual is a minor)
  • In response to a subpoena, court order or legal process, to the extent permitted or required by law
  • To protect the security and safety of individuals, data, assets and systems, consistent with applicable law
  • In connection the sale, joint venture or other transfer of some or all of its company or assets, subject to the provisions of this Privacy Notice
  • To investigate or address actual or suspected fraud or other illegal activities
  • To exercise its legal rights, including enforcement of the Terms of Use for this site or another contract
  • To affiliated Pearson companies and other companies and organizations who perform work for Pearson and are obligated to protect the privacy of personal information consistent with this Privacy Notice
  • To a school, organization, company or government agency, where Pearson collects or processes the personal information in a school setting or on behalf of such organization, company or government agency.

Links


This web site contains links to other sites. Please be aware that we are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of each and every web site that collects Personal Information. This privacy statement applies solely to information collected by this web site.

Requests and Contact


Please contact us about this Privacy Notice or if you have any requests or questions relating to the privacy of your personal information.

Changes to this Privacy Notice


We may revise this Privacy Notice through an updated posting. We will identify the effective date of the revision in the posting. Often, updates are made to provide greater clarity or to comply with changes in regulatory requirements. If the updates involve material changes to the collection, protection, use or disclosure of Personal Information, Pearson will provide notice of the change through a conspicuous notice on this site or other appropriate way. Continued use of the site after the effective date of a posted revision evidences acceptance. Please contact us if you have questions or concerns about the Privacy Notice or any objection to any revisions.

Last Update: November 17, 2020