In today’s low-growth, low-interest rate environment, banks face manifold challenges across virtually every segment of their businesses. The challenges are especially acute in capital markets divisions where sweeping regulatory changes have made traditional business areas, such as market making,difficult to monetize and to manage. Such conditions have pushed many banks to broaden their activities to include new products and strategies. One area that has become a primary focus is the development of Quantitative Investment Strategies (QIS)to compete with traditional asset management products. This burgeoning area offers significant opportunities for both banks and investors.
A QIS is broadly defined as the application of statistical and financial rules to a content-based investment strategy. This rules-based approach aims to deliver attractive investment performance without the unpredictability and higher costs of active human management. QIS should not be confused with high frequency or algorithmic trading strategies, which seek to place trades at speeds and frequencies impossible for a human or conventional trading system.
The increase in QIS development has come in parallel with the explosion of investor interest in passive investment vehicles. According to Morningstar, assets in passively managed mutual funds have grown 230 percent to $6 trillion since 2007. QIS is evolving as an extension to passive indexing, an effort to tailor the composition or behavior of an index or investment strategy with a set of smart rules.
QIS comes in many forms. Some strategies are as simple as weighting stocks in an index according to revenues or cash flow instead of traditional market-cap approaches or choosing the highest yielding dividend stocks in a given universe. More complex strategies can attempt to isolate exposure to specific factors such as value or momentum. Trend following or mean reversion strategies use pattern recognition to attempt to identify potential buy or sell signals. A given QIS tries to identify, based on history, a predictable pattern or persistence in market trends: high dividend paying stocks may move higher; markets may revert to their mean or average price levels. In creating these rules-based strategies, banks are able to strip away much of the “mystique” of active management and deliver sophisticated investment techniques with transparent guidelines and lower fees.
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QIS strategies are delivered in a variety of vehicles to investors. Many institutional investors opt to receive the return of a specific strategy in the form of an OTC swap. Others may choose to securitize the return in the form of a note or, increasingly, an ETF. A growing trend in the insurance market is to offer indexed annuity products tied to QIS strategies. As a natural extension of banks’ traditional derivatives expertise, many firms are offering options-based exposure to QIS. This necessitates that the investment rules be clear and concise and that there be sufficient liquidity in the underlying instruments. Clearly many factors must be considered when determining the optimal delivery vehicle for a particular QIS.
QIS provides advantages to banks and investors alike. For a bank’s capital markets group, a successful QIS business provides a content-based, predictable revenue stream. Almost all QIS strategies incorporate a transparent, disclosed fee that is paid based on outstanding notional and performance. Unlike a traditional capital markets business, which is purely transactional and resets to $0 at the beginning of the year, QIS looks more like an asset management business: recurring fees on a growing asset base which is content rather than risk focused.
For investors, QIS can provide access to tailored, transparent, rules-based strategies running the gamut from traditional markets to alternatives. QIS can combine the benefits of pure passive indexing with sophisticated techniques typically only available through active management. In particular, investors can employ QIS to access custom exposure to virtually any market factor or investment strategy at a fraction of the fees of alternative managers such as hedge funds. For many investors, the days of paying “2 and 20” for mediocre performance are over.
Given the regulatory and investment environment, the outlook for QIS is very positive. QIS provides very significant advantages to investors and providers alike. Banks are able to build scalable, fee-based and content-rich businesses while investors can gain transparent, tailored, rules-based exposure to an index or asset class. In an era where the advantages of passive investing are causing a seismic shift in the asset management industry,the rise of QIS is a natural progression.
Donald Dye is a senior capital markets and private equity professional. He has held senior positions at Morgan Stanley and the Royal Bank of Canada. He is currently Chairman and founding partner of Sky Lake Partners LLC, a real estate private equity firm, which manages partner and client capital in multi-family real estates in New York City.