Quantitative investor Raffaele Savi reflects on lessons learned in the financial crisis and offers some advice for investors conducting due diligence on quant strategies.

How have manager and investor attitudes changed?

Before the financial crisis, many quant funds wouldn’t disclose their trading strategies, reinforcing the view that quant funds are opaque. In the new world, transparency has become more important than ever before. Managers have to be able to explain how their strategies work, why they are likely to make money and how they manage the risks.

What should be the ultimate goal of the due-diligence process?

In my opinion there are three key questions:

  • Is the strategy diversifying relative to other strategies in the investor’s portfolio?
  • Does the manager have a genuine ability to deliver alpha beyond what can be explained by a combination of well-known risk premia?
  • How does this team think about risk and what are the lessons learned from the past?

"Managers have to be able to explain how their strategies work, why they are likely to make money and how they manage the risks."

How have you diversified beyond well-known risk premia?

I think the most exciting change is the rise in big data—web traffic, social media, text—and our ability to harness that into investment themes.

Ten years ago we used to receive approximately 1,000 broker reports a month globally. We would collect EPS estimates, recommendations and price targets and analyze trends in these metrics. And throw away all the textual information. Now we process 2,500 reports a day across 15,000 stocks worldwide, not to mention 15,000 annual reports and around 5,000 conference calls each quarter available real-time in text transcripts. The question we asked ourselves is, “Can we build an algorithm that reads text intelligently enough that we can use this massive advantage of breadth?” And it turns out that we can. That’s an advantage in understanding how information affects prices and investor behaviors and we are in the early stage of these trends.

What lessons have you learned?

These three lessons:

  • Crowded trades are more serious than we thought in 2007. We have become hyper-vigilant about understanding as much as we can about our competitors’ strategies and positions.
  • Quantitative strategies tend to be diversified, so in normal times you can be lulled into a sense of security and take on too much leverage. Then, when the once-every- 25-years storm hits, you realize that the fund is a lot riskier than you thought.
  • Third, you need to be aware of where you are in both the macroeconomic and market environments.

If you relied on fourth quarter 2008 earnings in the first quarter of 2009, especially for the financial sector, you probably missed the news that was really driving stock prices—the government bailout—and your performance suffered during the rally. So now we make an intense effort to understand signals in today’s market.