Quant Strategies: Theory vs Reality

Can Returns Seen in Research Be Achieved?

August 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The live performance of quant strategies is significantly worse than in backtesting
  • Factor investing returns from research are frequently challenged as being overstated
  • However, the performance of smart beta and long-short multi-factor funds match theoretical returns

INTRODUCTION

When pitching an investment product with a backtested history the frequent response from potential investors is that they have never seen a bad backtest. Naturally this is true as there is no point in marketing a strategy with a poor backtest as investors have zero interest in losing money. They also tend to chase performance.

However, it is somewhat challenging to respond to the criticism for the quant that ran the backtest. Most quants have a scientific education and are unlikely to champion discretionary investing. Especially given that most active fund managers have failed to beat their benchmarks over the short, medium and long-term as highlighted by the S&P SPIVA Scorecards.

Backtesting should be regarded critically, although it also depends on the type of backtesting. The more complex and innovative a strategy is, the more skeptical a potential investor should be. Theoretical returns of statistical arbitrage in Indonesian stocks are less likely to be replicated in reality than those of a Value strategy in the US.

The returns of plain-vanilla quantitative strategies as seen in factor investing literature should be achievable. In this short research note, we will contrast publicly available factor investing data and investigate if investors were able to capture theoretical returns (read Quant Strategies in the Cryptocurrency Space).

THE DARK SIDE OF BACKTESTING

Suhonen, Lennkh, and Perez analyzed the backtested and live excess returns of 215 quantitative strategies issued by fifteen investment banks between 2005 and 2015. The universe includes strategies from equities, fixed income, currencies, commodities, and multi-assets. The research paper shows a significant difference between the in-sample and out-of-sample performance.

Naturally some strategies are expec