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August 21, 2006
An Ode to Quant Investing
John Mauldin's always-excellent newsletter contains in its current installment a wonderfully self-serving ode to quantitative investing. The author, a strategist at Dresdner Kleinwort Watterstein, cites some lovely examples of where models outperform human judgement, and then asks the obvious question: Do quant models "...represent a ceiling in performance (from which we detract) rather than a floor (to which we can add)"?The first study I want to discuss is a classic in the field. It centers on the diagnosis of whether someone is neurotic or psychotic. A patient suffering psychosis has lost touch with the external world; whereas someone suffering neurosis is in touch with the external world but suffering from internal emotional distress, which may be immobilising. The treatments for the two conditions are very different, so the diagnosis is not one to be taken lightly.
The standard test to distinguish the two is the Minnesota Multiphasic Personality Inventory (MMPI). This consists of around 600 statements with which the patient must express either agreement or disagreement. The statements range from "At times I think I am no good at all" to "I like mechanics magazines". Fairly obviously, those feeling depressed are much more likely to agree with the first statement than those in an upbeat mood. More bizarrely, those suffering paranoia are more likely to enjoy mechanics magazines that the rest of us!
In 1968, Lewis Goldberg1 obtained access to more than 1000 patients' MMPI test responses and final diagnoses as neurotic or psychotic. He developed a simple statistical formula, based on 10 MMPI scores, to predict the final diagnosis. His model was roughly 70% accurate when applied out of sample.
Goldberg then gave MMPI scores to experienced and inexperienced clinical psychologists and asked them to diagnose the patient. As the chart below shows, the simple quant rule significantly outperformed even the best of the psychologists.
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Of course, all these quant models are based on historical data. If the future should be different from the past, caveat emptor.
Vanguard has several quant funds, Growth and Income VQNPX, U.S. Value VUVLX, Strategic Growth (closed), Strategic Small Cap Equity (new, no record), Asset Allocation VAAPX, Explorer VEXPX, Morgan Growth VMRGX, and Energy VGENX. I've probably missed a couple.
Of these, only the Energy Fund is doing better than the plain ol' Total Market Index Fund VTSMX which tracks the Wilshire 5000.