Acadian Asset Management

Investment Approach
Benefits of Acadian's Quantitative Approach to Global Equity Investing
June 2002

Acadian

Acadian has a rigorous and structured investment process. We quantify most aspects of our investment process, including the excess return we believe each security in our investment universe will generate over a particular horizon, and the risk we expect a particular portfolio to experience relative to its benchmark. The objective of this note is to explain why we believe a quantitative approach makes sense, and what advantages and disadvantages such an approach has relative to more traditional approaches. We believe that quantitative techniques are tools. They are ways of applying traditional approaches to making investment decisions in a disciplined and systematic way. Thus our approach to investing is not at odds with a traditional approach. We use the same tools many traditional portfolio managers use, but attempt to apply them in a very systematic and disciplined way, avoiding emotion and slippages in implementation. In a November 2000 research piece titled Evaluating Quantitative Managers, Brad Lawson of the Frank Russell Company defined quantitative managers as follows 1: Quantitative managers rely primarily on computer-based models to select stocks and construct portfolios. Subjectivity and insight are used to create the models, which contain the decision rules for selecting stocks. However, the actual individual stock selection process is objective; the decisions are made systematically by the computer according to predetermined criteria. Fundamental managers, in contrast, rely on the judgment of portfolio managers or research analysts to select stocks. This is a useful definition for contrasting quantitative and traditional managers. Acadian believes that there are several advantages that quantitative managers have relative to more traditional managers. These include greater breadth, more objectivity, less susceptibility to cognitive errors, a consistent, repeatable process, superior risk control, the avoidance of uncompensated sources of risk, and more effective implementation. We also recognize that there are some potential disadvantages, such as the absence of qualitative judgment in stock selection, an assumption of the continuation of historic statistical relationships, and potential difficulty in evaluating new industries. This paper will show how Acadian has structured its particular investment process to maximize the strengths of a quantitative approach and to minimize the disadvantages.

Breadth The value-added from any investment approach is determined by what Richard Grinold (former head of research at BARRA) has called the "fundamental law of active management."2 This "law" holds that the value-added from any active investment strategy is defined by the breadth of the investment universe (how many times you "come to bat" or how many investment appraisals you make over the course of a year) and by the information content in your investment appraisals (the correlation between forecasted excess returns and actual outcomes). Grinolds work shows that value-added is directly proportional to the breadth of the universe and to the square of the information coefficient. Thus, there is a real payoff to covering a broad universe of securities. Given two managers with similar levels of skill, the fundamental law suggests that the manager with the broader universe will achieve superior results. Quantitative approaches can be highly adept at achieving broad coverage. Acadian's approach covers over 20,000 stocks globally and uses a tremendous amount of information on stock valuation fundamentals, including input on company earnings prospects from thousands of security analysts. In a sense, what we have built over a number of years is an "automated security analyst" making continuously updated alpha forecasts on thousands of global equities every day. Of course, broad coverage is not useful unless investment skill is consistent across the entire universe. Unlike a conventional analyst who probably covers only a limited number of stocks in depth, another group of companies with somewhat less depth, and then perhaps an additional list of stocks in only a cursory way, Acadians investment process applies the same depth of insight and analysis to every single stock in its investment universe. This means that our forecasts are truly comparable across stocks, and we have no bias towards buying a stock that we simply happen to know more about. As an example, a more traditional firm would generally have difficulty in following the thousands of stocks that Acadian actively monitors in our small-cap universe. Acadians actual achieved information ratio for small-cap portfolios, close to the level of one since 1993, is compelling evidence, we believe, of the capabilities of a structured process in this very broad universe. Objectivity We believe quantitative approaches also benefit greatly from their innate objectivity. More traditional, bottom-up firms are reliant upon a limited number of security analysts to develop winning investment ideas. If the traditional firm assigns only a limited number of stocks to each analyst, then conceivably the analysts might be able to come up with some unique insights as to earnings trends or growth prospects. In practice, however, our experience leads us to be skeptical about the likelihood and repeatability of these kinds of insights. As we have seen recently with several highly publicized examples (e.g., Enron), it doesn't appear that traditional bottom-up security analysts have had much, if any, edge at all. In fact, the all-too-human tendency to succumb to charismatic and misleading corporate executives has led many analysts far astray.

In contrast, Acadian can take advantage of the full spectrum of analyst forecasts and tailor its use of this data to focus on the most skillful analysts in each industry. In Acadians large-cap global equity portfolios, the average stock is followed by over 20 security analysts providing earnings estimate data into our valuation process. We have found that there is more predictive information in this array of data than in a single analyst's forecasts. Moreover, this information is incorporated systematically and consistently in our process, where the same decision rules are applied over and over. Unlike individual analysts who sometimes fall in love with a stock and feel they must defend their recommendation even as the ship goes down, in a quantatitive process there is no emotional attachment to any particular company. Buys and sells are based solely on empirical evidence. In addition, a structured process is inherently contrarian, which is likely to be a winning approach to investing in global markets. More traditional and subjective approaches are unfortunately often prone to behavioral problems such as trend-following and getting too enthusiastic about a stock or market just as it is about to peak. Corporate and popular culture encourages a policy of rewarding winners and punishing losers, both in stock selection and asset allocation. Yet, in the investment world, a policy of paring back on winners and favoring losers has provided better returns in stock selection and asset allocation. Less Susceptibility to Cognitive Errors Behavioral finance has found a number of cognitive errors to which all investors are susceptible. Quantitative managers avoid many of these systematic errors, since we use consistently applied decision rules. Some common behavioral errors include loss aversion, where investors become risk-averse when faced with a loss; overconfidence, where investors think they have more skill than they really do; extrapolation of the recent past, in which people tend to think that current trends are likely to continue; and anchoring, where investors pay excessive attention to old information and underreact to new information.3 All of these errors can lead more fundamentally-oriented firms to make suboptimal investment decisions. For example, during the technology boom many analysts were overconfident and extrapolated the recent past in predicting continued strong earnings streams for telecom companies, despite clear evidence of overcapacity in the telecom market. Another example is Chrysler, a stock which had been characterized as a loser for so long that many analysts dismissed evidence of positive changes such as the introduction of the minivan and an explosion of renewed profitability for the automaker. Quantitative approaches can avoid these kinds of behavioral errors. In Acadians process the cost basis of an investment has no bearing on its current attractiveness, so we do not react emotionally to a potential loss when selling a security (a phenomenon that can lead fundamental firms to hang on to bad stocks for far too long). We measure the efficacy of the various parts of our process explicitly, know objectively what our skill is, and do not seek to make bets in excess of our expected forecasting ability. A quantitative approach is also completely objective in its treatment of new information, without the bias imposed by past conceptions of a company and its prospects. In Acadians process new information is immediately utilized in forming our return expectations, without the delay that often occurs as human cognition works to adjust to new conditions. Research has shown that

human beings can keep track of no more than seven or eight changing parameters at once in decision-making. When investing globally, there are many more changes taking place economies, currencies, security prices, earnings expectations, and so on, across thousands of stocks. A quantitative framework provides a tool that allows these changes and their impact on expected security returns to be captured immediately and consistently. Risk Control and Avoiding Uncompensated Sources of Risk Quantitative managers typically use risk models to help them create portfolios with a certain level of expected risk or tracking error versus their benchmark. These risk models also provide some insight into the sources of risk in a particular portfolio. For example, is the active risk coming from stock selection, from asset allocation, from country or sector allocations, from market cap, or investment style deviations from the benchmark? For structured processes in general, a major advantage is the ability to avoid unintended and uncompensated bets. Traditional, subjective managers often dont seem to know what their bets are or, if they do know, how likely they are to be compensated with excess returns. Acadian seeks to minimize uncompensated sources of risk in our portfolios, and to have a good handle on the overall tracking error a particular portfolio is likely to deliver. While the risk predictions we make are not always accurate in any one year, over time all of our strategies have delivered risk levels in the range we have targeted. Minimizing Implementation Drags A further argument favoring a structured process is transaction cost control. In Acadians approach, transaction costs for all the stocks in our investment universe are estimated for each potential trade, and these are appraised relative to the potential gain in alpha from making a trade. Since it is very easy to dissipate portfolio alpha through trading costs, we believe this continual emphasis on transaction cost control provides an important edge. Other implementation drags that can impact more fundamental managers include slow implementation of new information into alpha expectations and into portfolio positions. Acadians process is based on an open and continual flow of new information such as prices, earnings, analyst forecasts and other data -- which is automatically incorporated into our alpha forecasts. We recalculate our expected security alphas after the close of each major time zone, three times a day. This real-time response to new information up to thirty factors for each stock, analyzed in-depth according to their intricate interrelationships would obviously be impossible for a human analyst to achieve daily on even a few stocks, let alone 20,000. Acadian also has the ability to examine each portfolio we manage daily, to determine if additional trading is needed. This kind of real-time, dynamic portfolio management is a strong hallmark of quantitative strategies. Assessing the Negatives As noted above, in addition to their advantages, there are some potential downsides to quantitative approaches. Any model is a simplified representation of reality. At Acadian, our models are as parsimonious (in terms of the number of factors) as we can make them without

reducing their predictive efficacy. However, it is possible that a good fundamental analyst theoretically could consider types of issues beyond those we explicitly incorporate in our models. Factors that are difficult to quantify include management quality and longer-term potential demand for new or existing products. At Acadian, we try to capture these kinds of factors by using proxies that can be quantified. For example, we explicitly incorporate analysts ratings of companies into our security evaluation in a way that captures useful information not already embedded in earnings forecasts. Another point to consider is that quantitative managers generally base their return expectations for securities on historical evidence for past payoffs to particular security characteristics. But these relationships evolve over time, and if markets undergo radical change, quantitative managers can underperform. One important way Acadian addresses this problem is through the use of careful judgmental inputs or priors in determining return expectations based on various security characteristics. Priors are simply expectations based on investment principles or other information not already captured in the historical data. For example, rather than just using the long-term alpha observed from a certain book to price ratio to project future alpha, we use a prior expectation of what that alpha might be, along with a level of confidence in that prior, and combine this with the historical data. This provides an integrated, consistent way to go beyond using purely historical data, when appropriate. Thus, if we have a forward-looking model for the return to a particular factor, or if we are clearly experiencing bubble-like conditions for a particular factor, Acadian can utilize these priors to avoid over-reliance on historical data. The evaluation of new industries is another area where careful use of priors can help Acadian avoid a typical quantitative disadvantage. At the height of the Internet bubble, conventional valuation approaches suggested all Internet companies were wildly overvalued. It appeared that quantitative managers especially were unable to come up with appropriate metrics for evaluating companies in new industries. While in this case quantitative managers turned out to be correct, the point is not completely wrong-headed if new valuation factors are appropriate to evaluate new kinds of companies, quantitative managers can lag in utilizing these because of the requirement for some data history to evaluate such factors. At Acadian, we believe the advantages of our approach obvious in retrospect when evaluating Internet companies outweigh the disadvantages. We also put a lot of effort into evaluating new predictive factors for stock selection and testing these across a variety of sectors. Overall, we believe our process has significant advantages in our ultimate pursuit of value-added on behalf of our clients. The key, of course, is to have a forecasting process that is demonstrably strong. Our experience has shown that at the individual stock level there are a wide range of inefficiencies that a structured process can exploit. Such opportunities to add value through use of Acadians rigorous process is shown by the success of our investment strategies, which in recent years have information ratios ranging from 0.5 to 1.0 and higher. Our objective as an active equity manager is to deliver information ratios of 1.0 and higher to our clients, and all the evidence we see suggests that a well-designed, quantitative approach to global equity investing has the best chance of doing so over time.

1 2

Lawson, Brad. Evaluating Quantitative Managers. Russell Research Commentary, November 2000. Grinold, Richard, The Fundamental Law of Active Management. Journal of Portfolio Management, Spring 1989. 3 DeBondt, Werner F.M., Investor Psychology and the Dynamics of Security Prices. Behavioral Finance and Decision Theory in Investment Management, Arnold S. Wood (ed.), Charlottesville, VA: The Institute of Chartered Financial Analysts, 1995.

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