May 2017

Investment Insight: Smart Data, Big Beta and the Evolving Land of Quant
Eric H. Sorensen, Ph.D.

The Prediction

In the aftermath of the financial crisis a decade ago and the dramatic decline in equity values that followed,
we published a Journal of Portfolio Management article regarding the future of active equity management
(Sorensen, 2009).

At that time , we highlighted two key prognoses concerning future requirements of investment managers.
Managers needed to 1) embrace a diversity of approaches across the active investment arena; and 2)
embrace the necessity to differ from each other in the ways they access and leverage information in terms
of their information sources, information processing and information implementation. We further noted
that, Catchy yet misleading phrases and fads will also come and go, as will the next batch of superficial
marketing-driven and noise creating buzz. Headline examples of just such labels subsequent to our writing
are rampantly evident today: Big Data and Smart Beta, to name two. i

In part, these labels relate to our earlier prognoses; however, the underlying forces that encouraged the
creation of these titles are having a profound impact on new diversity amongst strategies. More generally,
the movement addresses two requirements; first, innovating strategies that take the other side of the
trade by creating a diversity of alternatives to Big Beta --- a.k.a. price-weighted portfolios;ii and, second,
embracing the proper attitude toward the data endeavor --- Smart Data, meaning proprietary and intuitive--
- be it small, mid-sized or big. A decade ago, we expected that we would see the evolution of
quantitative investing marked by small, diversified and additive elements of innovative information
analysis In the end, technological and information innovators would simply be called good investors.

But in order to fit the bill of Smart Data, technology must serve the data, and not create or distort it. For
example, we did not envision the staying power of high frequency trading (HFT) which is all technology-
driven, but may be potentially destabilizing as it is void of any economic intuition. In the past 10 years, it has
been more of an arms race than an exercise in creative investing. As a result, the viability of profitable
economics has virtually vanished. Aggregate revenue for the HFT players has shrunk from $7 billion in 2009
to $1 billion today.iii The game may be worth winning, but not worth playing.

Below we expand upon and further explore - the predictions in that 2009 article. We emphasize the
importance of innovative data that adds value ---- and is not necessarily a subset of the ballooning mass of
big data. What should be considered the optimal, or smarter, approach the incorporation of specific
data characterized by fundamental intuitive underpinnings, reasonable investment horizons and closer to
proprietary than ubiquitous. Further, we comment on the broadened opportunities for quantitative
investors to embrace a more diverse set of portfolio strategies --- well beyond the historical constraints
inherent in the alpha versus beta separation paradigm. Alternatives are expanding, and coming out of

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the alternative bucket into the main. This is evident in the risk premia opportunities (Risk Parity) as well as
within asset classes strategies. Innovative quantitative practitioners are blending both alpha and beta in
very effective (and diverse) ways. Smart Beta, if implemented properly, effectively accesses alpha with
factors and also moves beta away from the crowded capitalization-weighted variety (Big Beta) which
carries excessive volatility. Smart Beta is evolving into alpha-beta, and we will see approaches that can
dominate wealth creation over reasonable horizons. Moreover, there will be differentiation across
providers to this end ---- lead by the most innovative quantitative managers.

The Credit to Financial Economists

Over the past 40 years, financial economists and academicians have made significant advancements to
modernize the world of asset management much like scientists contributions have improved the quality of
their respective areas of discipline, be it medicine, communication, digital technology or travel. This rich
legacy can be summarized: 1. You should Earn Returns Consistent with Risk Taken a.k.a. Asset Pricing
Equilibria; 2. You should Earn no More than Expected Returns a.k.a. Asset Pricing Competition; 3. But ---
should You Beat the historic 9.3% Lorie and Fisher finding, it must be an Anomaly a.k.a. Asset Pricing
Behavior; 4. You should use Modern Techniques to Model Future Price Behavior a.k.a. Asset Pricing
Econometrics (Quant).iv

The early pricing research was descriptive. As the financial markets matured post the 1970s, the descriptive
became normative.v (Both Bill Sharpe and John Bogle have been rewarded, for example.) Theory became
practice, as the financial economists and econometricians broke the new ground.

The CDS versus the CIO

Will the Chief Data Scientist (CDS) be the new CIO? Will intense focus on massive data drive investment
organizations? Will the CDS take over the landscape? We think not. However, watching the headline news
of the recent past, one could argue the opposite --- the artificial intelligence guru and the big data groupie
have both become hip. For example, large institutions, such as BlackRock, are embracing the buzz and
undertaking a venture in AI [artificial intelligence], a whole group of people working on developing
computer-based investing. And thats truly a computer saying, --- Buy this. Sell that.vi

Is this effort new? Quants have been working with large amounts of financial and other relevant data using
computers for 40 years, and have subsequently been persecuted for data mining, despite widespread
innocence. It seems that true scientific data mining (akin to fake news) is suddenly highly respectable.
Perhaps the present scientific torturing of large data is somehow new. Or perhaps, Solomons wisdom
applies again --- The thing that hath been, it is that which shall be; and that which is done is that which shall
be done: and there is no new thing under the sun.vii

A recent study by Citigroup is very enlightening regarding the business of big data.viii And big it is. It is big
in dollars and big in space. Much of it must be stored and processed on the Cloud. The list of providers
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covers considerable breadth --- satellite imagery, credit card data, and clicks to name a few. Rumor has it
that the self-identified big data firms total in the hundreds and reportedly generate an aggregate $50 billion
in revenue annually.

Our observations regarding data are, on the one hand: 1) big alone is not a sufficient condition for added
value --- big but not smart (or causal) is potentially spurious; and 2) big brings perverse results if
everyone uses it. On the other hand, smart data may be sufficient. Smart data, among other things, is not
commercially ubiquitous, is given to reasonable investment horizons and is rich in fundamental intuition.

Our first encounter with smart data dates to the early 1970s. A major industry of the Pacific Northwest was
forest products, Weyerhaeuser and Georgia Pacific to name a few. One innovative analyst determined that
during periods of rising interest rates (building slump) versus falling rates (building boom), a small (versus
large) lumber inventory separated the winners from the losers. Consequently, he hired a helicopter pilot to
routinely fly him directly over the lumber yards adjacent to lumber mills, as well as active logging sites, to
assess the potential inventory levels. The helicopter data was proprietary and intuitively causal. Most
importantly it worked, providing valuable company insights.

Forty-five years later the contemporary version of helicopter data is satellite imaging of shoppers parked
cars. Todays modern space technology version is big and it seems causal. However, it may fail if everyone
has access to it. Ubiquitous is neither proprietary nor innovative which means it fails to be smart.ix

The Maturation of Quant

Two currents of change across the investment industry are indisputable. First, quantitative investing is rising
in status. Practitioners no longer operate within a rigorously resistant, anti-quant world. The social and
multidimensional case for quantitative solutions has steadily gained a plurality of acceptance, as well as
occasional applause.x

Second, the landscape is becoming alternatives everywhere. Moreover, quantitative investing is at the
forefront of the alternatives movement. In many instances alternative strategies that have historically
resided in a separate portfolio allocation (adjacent to the traditional asset mix) are coming out of the
bucket. New data, strategies, and techniques generate diversity. Several decades ago all investing was
alternative, by simply generating returns with a portfolio that lacked intentional or inadvertent overlap in
holdings from others in a variety of ways.

As time passed, homogeneity set in. The CAPM and the separation of alpha and beta underwent
institutionalization. It unwittingly limited considerable potential for material diversity. For example, the
increased commonality of quantitative equity began to follow an all-too-recurrent pattern that has
historically plagued other successful strategies. The plague has a pattern: creative brings on copied. In time,
this brings crowded, finally leading to illiquid capitulation. During 2006 2007, U.S. equity quants found
themselves in this trap ---- common brains, benchmarks and betas leading to common bets --- ultimately
needing to be unwound.
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Around that time, we were recommending divergence from communal strategies. The comment was to
shift some of what we were calling alpha to beta, and some of what we were calling beta to alpha. xi
Admittedly, talking beta-to-alpha and vice versa seemed vague, or worse, sacrilegious, to many listeners.

The classic one-period risk/return tradeoff needs to be recast for making active decisions. The traditional
picture houses return on the vertical axis, risk on the horizontal axis and asset classes (portfolios) in the
body arrayed from lower left to upper right. Two important influences are altering the depiction: 1) the
increased acceptance of modern investment apparatus created with quantitative tools; and 2) the pressure
on investment costs (fees), which are now becoming increasingly transparent. We posit that the actionable
trade-off graph should perhaps be wealth accumulation (incorporating return, risk and horizon) on the
vertical, total costs on the horizontal and portfolio strategy allocations in the body from lower left to upper
right. There is wealth accumulation (W) versus fees paid (F), or WF graph. Specific allocations (of strategies)
that exhibit stochastic dominance with higher holding period returns over others should lie along an upward
sloping array from lower left upper right.xii The vertical axis incorporates both what the industry has called
alpha and beta. Some combinations will accumulate more wealth and justify higher fees as we move right
on the horizontal axis.

Quants have long had a rich taxonomy for risk. Now, fee pressures on traditional fundamental approaches
are affording quants the opportunity to maneuver beyond the alpha and beta separation paradigm.
Fewer constraints bind their opportunities. This has invited innovation to mix alpha and beta in a strategy.
That is effectively what smart beta becomes when incorporating traditional alpha factor tilts with a better
portfolio construction scheme. Moreover, the high degree of efficiency simultaneously permits more
reasonable fees. Hedge fund managers have always enabled themselves to have an unconstrained long
bias mixed with a variety of bets. However, in aggregate, traditional hedge funds may have failed to
consistently create wealth at tolerable fees.

Quantitative approaches can now deliver a higher W to F ratio with an outgrowth of alternative asset risk
premia options such as multi-asset risk parity and alternative beta, as well as smart beta (alpha beta mix
alternatives) strategies. Risk parity, smart beta and others, such as quantitatively managed futures, now find
a well-deserved habitat along the W to F graph. This has rendered obsolete the old active versus passive
debate. xiii Price-weighted indices have a role, but to a much lesser extent than in the past. Better and more
diverse strategies are coming out of the alternatives bucket and into the mainstream.

At Salomon Brothers in 1987, we deployed the first large-cap US equity factor model with dedicated pension
assets.xiv The introductory research report included the term multi-factor in the title. Few institutional
investors appreciated it when we effortlessly mapped their fundamental portfolios of stocks into a set of
factor exposures. This year (May 2017), the Journal of Portfolio Management devoted a special issue with
multiple research papers on factors --- a term no longer needing quotes.xv

The post-tech-bubble period witnessed a rise in quantitative equity portfolios. In 2007, quant equity AUM
peaked, and subsequently underwent a major decline. The financial crisis was the catalyst, but the collapse
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was exacerbated by commonality in quant approaches -another market episode of create, copy, crowd, and
capitulate.

A few very large providers dominated this 2007 peak. Since 2010 the renewal of growth has been different.
Growth is: 1) led by boutique and mid-sized managers of lower average AUM; 2) characterized by diversity
in approaches across those managers; and 3) augmented by the penetration of alternative and/or smart
beta --- executed in a number of different ways.

The labels of smart beta or alternative beta are probably fine. However, shouldnt we think of this as an
alpha beta mix? Originally, the mathematical techniques used to create alternative beta were applied to
achieve better diversification. Our colleague, Eddie Qian Ph.D. [2006], first used the expression risk parity
in print. His approach differs from the many others, and further applies to both single and multi-asset
portfolios. Innovation of alternative beta such as this provides plan sponsors with new approaches to
consider for their asset allocation mix. Given these new choices for running equity portfolios, about half of
the universe of large pension plans has adopted alternative beta allocations, primarily for the purposes of
diversification. In fact, global alternative beta AUM represents about 5% of total global equity assets.

More recently, investor motivation has shifted to return enhancement, similar to the motivation for
traditional quant equity decades ago. However, this time around there is freedom from anchoring to the
price-weighted behemoth. In addition, factors are creeping into the process. The appetite for low volatility
portfolios, particularly in Europe, was a tip-off to changes in preference.

Today the label smart beta should be considered a factor tilted or alpha tilted long-equity strategy. We
would also offer a label such as quantitative alpha beta mix portfolios that mix the diversification benefits
of lower volatility (via alternative beta mathematics) with the benefits of factor-enhanced returns. The
enhanced comes with the traditional quantitative factors such as quality, value, yield, momentum and so
on. Newer creative factors are also candidates. In addition, there appears to be an increasing institutional
preference for longer holding period horizons. The AUM of quantitative alpha beta portfolios is now
reaching the level of more mainstream multi-factor portfolios.

The Olympics of Quantitative Equity Management

What is the difference between the original factor portfolios that grew from 1987 to 2007? How do we think
about the differences and the choice between traditional quant equity and some version of smart beta?
Sports metaphors work.

Consider the profile of a successful athletic team. Teams are comprised of good athletes. Sometimes the
teams have a preponderance of skilled, all-around athletes. For example, a basketball team has individual
players at skill positons, but all need to shoot baskets on offense and block baskets on defense. Contrast
this to American football, where the skills of each player are more specialized, with players being members
of either the offensive or defensive team.

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The Olympic Games represent a much more apt sports metaphor. Modern Olympic teams comprise a large
number of athletes highly focused on non-diversified, specific skills --- run, jump, throw or lift etc. The
discus thrower need not possess attributes required of the 100-meter sprinter (and vice versa.)

Contrast this specialization focus to the diversified talents of the pentathlete or decathlete, participating in
five and ten events, respectively. Jim Thorpe won the Olympic pentathlon in 1912, and some still consider
him the most versatile athlete of all time. He was excellent in several individual events and team sports.
This invites our metaphor.

The evolution of quantitative equity has a resemblance to the history of the Olympics. According to
historians, the first matches were likely dated 776 BC. Initially, there was one event ---- running the
stadium race, a 200-yard sprint. However, very quickly more events were innovated. The events grew in
number, but the number of participants did not proliferate. Each contestant now had to participate in each
event, and the winner had to (more or less) score well in each event to win. This innovation was the
pentathlon, a five-event contest of running, jumping, discus throwing, javelin throwing and wrestling. The
pentathlon contestants were singular men competing in five events. To enter - and indeed to win - the
individual had to, on average, score highly. The highest weighted average score was tops. Does this sound
familiar to the traditional quant portfolio process?

Selection of participants is like the traditional quantitative ranking process for portfolio inclusion. The top
decile stocks are good on average. A weak attribute, such as quality, has to be offset by a strong attribute,
such as value. All stocks (participants) compete for the top decile --- individually. The resulting portfolio
constituents are all Jim Thorpes to varying degrees, competing for the high composite score. This is the
five-factor model --- the pentathlon portfolio process.

Fast forward in Olympic history and we see a plethora of added events. Today, track-and-field alone
comprises a vast array of individual events. How does the coach select the potential winners for todays
Olympic team? It is primarily by specialization and not by composite skill. The 165-pound sprinter makes
the team and so does the 300- pound hammer thrower. The team is made up of small groupings of
specialized athletes --- a group of runners, a group of throwers, and so on. In this case, the selection of
participants is like the alpha-beta mix process for portfolio inclusion --- a sleeve of momentum stocks (group
of runners), a sleeve of high quality stocks (group of throwers), and so forth.

Let us assume for illustration that the track coach has to choose one method to field the team: select
generalists or specialists. The two choices are: 1) individual athletes, each with all around strengths; or 2)
sub-teams of athletes with homogenous strengths within. This is the quant equity metaphor, whereby you
either populate a team with: 1) single stock multi-factor selection processes; or 2) alpha-beta mix processes
with multi-factor exposures comprising single-factor tilted sleeves.

Both approaches are viable. Both have a future. The traditional approach is the evolved product of the four
areas of academic breakthrough cited in section 2 above. The creators worked around the price-weighted

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shackles with quant equity long-short portfolios. However, even this carried restrictive constraints and
headwinds.

The smart beta strategies of late have met the price-weighted heavyweight straight-on. These strategies
represent recognition that there is an alternative approach to better diversification and lower volatility. The
surgical implantation of factors into the mix inaugurates a new chapter for active quantitative equity,
namely, the marrying of elite security selection with elite portfolio construction.

Forthcoming, there will be synthesis. Granted, our metaphor for these two approaches is a bit simplistic.
The good news is they are not mutually exclusive. In combination, investors will take quantitative investing
to the next level. For example, tomorrows portfolios will have components with multiple horizons. A sleeve
of momentum stocks with very short-term exposure will coexist with a traditional multi-factor set of
holdings. One position will complement - not impede or constrain - the other.

The Way Forward

Quantitative strategies will continue to contribute to the investment industry. They bring a much richer
diversity of solutions that include across-asset class premia and within-asset class portfolio enhancement.
Two battlefronts of innovation will separate the better quantitative investors from traditional adherents: 1)
the fight for superior information processes such as smart alternative data that is creative and un-abused;
and 2) the fight for innovation in efficient portfolio construction, with fewer constraints such as smart alpha-
beta blending. That is, the researchers will seek better inputs and better recipes. In that sense, and at a
higher level, Solomon is right --- There is nothing new under the sun.

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References

Bower, R.S., and D.H. Bower. The Salomon Brothers Electric Utility Model: Another Challenge to Market
Efficiency. Financial Analysts Journal, Vol. 40, No. 5 (September/October 1984), pp. 57-67.

Fama, E. Efficient Capital Markets: A Review of Theory and Empirical Work. Journal of Finance, Vol. 25, No.
2 (May 1970), pp. 383-417.

MacKenzie, D. An Engine, Not a Camera: How Financial Models Shape Markets. Cambridge, MA: The MIT
Press, 2006.

Qian, E. Risk-Parity Portfolios: Efficient Portfolios Through Diversification. PanAgora Asset Management,
2005.

Qian, E. On the Financial Interpretation of Risk Contributions: Risk Budgets Do Add Up. Journal of
Investment Management, Vol. 4, No. 4 (2006), pp. 41-51.

Sharpe, W. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. Journal of
Finance, 18 (September 1964), pp. 425-442.

Sorensen, E.H. , K.L. Miller and V Samak. "Allocating between Active and Passive Management. Financial
Analysts Journal, Vol. 54, No. 5 (Sep/Oct 1998), pp. 18-31.

Sorensen, E.H. Active Equity Management for the Future. Journal of Portfolio Management, Vol. 36. No. 1
(Fall 2009), pp. 60-68.

Sorensen, E.H. and N. Alonso. The Resale Value of Risk-parity Equity Portfolios. Journal of Portfolio
Management, Vol. 41. No.2 (Winter 2015), pp. 23-31.

Treynor, J. Market Value, Time and Risk, Unpublished manuscript, 1961.

Treynor, J. Toward a Theory of Market Value of Risky Assets. Unpublished manuscript, 1962. (A final
version was published in 1999, in Asset Pricing and Portfolio Performance: Models, Strategy and
Performance Metrics, edited by Robert A. Korajczyk, pp. 15-22. London: Risk Books, 1999)

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For institutional use only.

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i
Quantitative investing has seen many hyped fads come and go.
Most emanate from the engineering and scientific communities.
Included are neural networks, chaos theory and genetic
algorithms. These have come and gone. These catch phrases will
not be the last examples. AI may work with driverless cars and
chess in which there is a large (but finite) set of rules and options.
In stochastic markets characterized by uncertainty with limitless
options --- AI is more hype and hope than heroic. The money
management industry is not immune from creative marketing that
can discolor creative investment strategies.
ii
See Sorensen and Alonso [2015] for a discussion of the evolution
and dominance of Cap-weighted approaches, and their pitfalls.
iii
WSJ, March 22, 2017 High-speed Trading hits Profit Pothole.,
p. b13.
iv
Tons of published research is readily available.
v
For a narrative history of how theory became normative see
MacKenzie [2006]
vi
Bloomberg Markets, Vol 26, Issue 2, p. 68, Interview with Larry
Fink, April, 2017.
vii
Solomon, The Bible, Ecclesiastes Chapter 1, verse 9, around 950
BC.
viii
Citi Research, Searching for Alpha: Big Data, March 10, 2017.
ix
My colleagues tested parking lot data for the 2010 2013
period. The backtest was striking --- a 30% cumulative long-short
return. Post 2013 the return became negative, and remained so
thereafter. It was in 2013 the vendor sold the data to
subscribers.
x
This author has experienced over 40 years of quantitative
research, modeling and implementation penetrating the
institutional landscape. Hundreds of us have. Way to go.
xi
After writing Sorensen [2009], we had occasions to addressed
quantitative audiences at various conferences. My prescriptions
included: 1) move from tinkering to real innovation, 2) move
away from commonalities, 3) move some alpha to beta, 4) move
some beta to alpha, 5) move from tracking to volatility, and 6)
move from then cap-weighted crowd.
xii
See Sorensen and Alonso [2015] for a review of the second-
order stochastic dominance and an example of risk parity
weighted equity dominating capitalization-weighted equity over
reasonable holding period horizons.
xiii
See Sorensen and Miller [1988].
xiv
The basic approach we called the E Model that modeled the
level, risk and projection of EPS using a factor weighting approach.
Stocks with high composite ranks made the portfolio. One specific
public fund ran the E Model tilt against cap-weighted indices
during the 1987 1995 period with demonstrated and consultant-
audited superior returns.
xv
Journal of Portfolio Management, Quantitative Strategies:
Factor Investing, Special Issue 2017.

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