I have spent most of my working life trading
and creating strategies for trading groups.
At the beginning of my career,
quant trading was dominated by arbitrage strategies that
today we would consider quite slow and simplistic.
Despite that, the strategies were quite profitable.
Markets have become much faster and more efficient,
and strategies have evolved to identify and exploit
opportunities that are available for
a few milliseconds and then disappear.
The strategies that you will
create don't have to be perfect.
Actually, perfect doesn't exist in the trading world.
They just need to be as good or better
than the ones that your competitors will be using.
First, we will discuss the differences
between trading and investing.
We will also identify
the main strategy categories in the Quant Universe
and then gain an understanding of how
each component fits into a quant strategy.
Lastly, we will point out the strong points and
weak points of typical quant strategies.
In this section, we will explore the design and
implementation of quantitative strategies in trading.
We will talk about the different parts
of the Quant Universe and
then explore the main types
of quantitative trading strategies.
First, let's talk about trading versus investing.
Financial sector firms are usually
designated as either buy side or sell side.
Buy side refers to firms
whose primary business is investing and advising.
This group includes asset managers such
as private equity, mutual funds,
life insurance companies, pension funds,
and quantitative trading firms such as hedge funds.
Sell side refers to banks and broker dealers
that sell investments and services
to asset managers and hedge funds
and that also provide market-making services.
That means they act as dealers in secondary markets.
At investment firms, we find
portfolio managers make longer-term decisions about
the strategic allocation of assets and
somewhat shorter-term decisions
about the tactical allocations.
Strategic allocation decides how much to
invest in each asset category such as equities,
bonds, real estate, or commodities.
Tactical allocation chooses specific assets
to buy or short within each category.
The most common investment strategy is to buy and hold
assets that had been identified as
undervalued based on fundamental analysis.
Portfolio managers' gains and losses are
measured relative to a relevant benchmark,
portfolio, or index which mirrors
their strategic allocation in their portfolio.
This performance is measured net
of any moves in the benchmark or index.
So they can only outperform if their asset choices
beat a passive portfolio that mirrors the benchmark.
Hedge funds on the other hand,
we find traders, developers,
and researchers all working
together to identify
and implement quantitative strategies.
Their goal is to generate
a positive return that is
independent of overall moves in the market.
This hedge return is called Alpha.
The term Alpha is also widely used by portfolio managers
to refer to their outperformance
or return above a benchmark.
This excess return seems
similar to the Alpha generated by hedge funds,
but there's an important difference.
Portfolio manager Alpha comes from
long asset holdings that are exposed to market, sector,
and company risk as opposed to
hedge fund Alpha which comes from
a hedge strategy that has
eliminated or at least attempted to minimize these risks.
This is one of the key benefits
of investing in a hedge strategy,
especially if you're worried there'll be
a sell off in the overall market.
Portfolio managers use fundamental analysis
to rebalance the allocations in their portfolios.
Rebalancing includes changes in the strategic allocation
to give undervalued asset
categories a heavier weight in the portfolio.
It can also include tactical reallocation,
where ideally you're selling winning assets
that have achieved their full target value and replacing
them with undervalued assets that have the potential to
help the portfolio achieve
returns in excess of its benchmark.
At trading firms, traders have
a much shorter-term opportunistic focus.
The time frame for their investments ranges
from a few months to a few milliseconds.
A millisecond end of
this spectrum dominates over all trading volume.
Traders rarely use fundamental analysis
as a factor in their decisions as they consider
this information to already be baked in to
the market price and
essentially worthless for generating Alpha.
Traders instead look constantly for market behaviors and
inefficiencies that will generate
high-risk adjusted returns on their trading capital.
Although they trade the same assets
as portfolio managers,
they generally ignore fundamentals and
focus on other sources of mispricing.
Buy-side quantitative methods include regression,
prediction models, statistical arbitrage,
and machine learning which
we'll cover later in the course.
Sell-side quantitative methods are
mostly execution strategies.
These are designed to reduce the market impact cost of
large orders and also to capture
spreads by providing liquidity through market making.
Keep in mind though that buy-side firms also employ
execution strategies when they
execute their trading orders.