Quant Achilles Heel

Some quants systems no doubt focus on either one vector or one factor. Some are no doubt multi-factor. While the truly ambitious are no doubt seeking a unified theory of the markets, ie. try and incorporate all known anomalies.

Such a system would incorporate small cap bias, momentum bias, quality bias, value bias, broad diversification, red flags.

It is the red flags area where short sellers focus. Myriad changes reflected in a firm's accounts may point to warning signs. You can model those and you can model management quality (based on history), but identifying frauds or accounting shenanigans is an incredibly subjective endeavor when the data points you are working with are inconclusive (and they are always inconclusive).

I guess that is why "fundamental based", qualititative oriented investors are now getting caught with their hands in the cookie jar, ie. insider trading. Finding and getting an edge is extremely difficult.

On a side note. I am amazed when I look at so-called small and micro caps where the marketing material of managers in the space talk about inefficiencies due to lack of coverage, that the stocks are generally fairly valued. Now fairly valued is in the eye of the beholder, but there are few glaring mis-valuations from what I can see across the whole spectrum.

Now back to the quants achilles heel. The rigidity of their systems (whether is a static set of criteria or pattern recognition algorithms) or the backward looking nature of the learning systems mean that quants will always miss the nuance of something and/or miss the change in environment because they lack cognitive awareness. And they will never catch the subjective dimensions of not trusting management that comes from a visceral gut feeling.

A Developing Thought - Traditional Security Analysis as Scholastic Philosophy

In the same way traditional security analysis sought to justify rationally, ie. put a structure around, what the marketplace already accepted so Scholasticism sought to justify rationally what the church had already accepted.

The main schools of thought during the scholastic period were universalia ante rem (essence precedes existence) and universalia post rem (existence precedes essence) arguing over what came first or what comes first, essence or existence. The same can be applied to security analysis with regard to whether fundamental value comes first or market price comes first.

In the ethical/moral realm scholastics guiding light was summum bonum (absolute good) as the yard stick for devining whether something was good (a relative value basis). In security analysis there is the implied belief that there is some fundamental/intrinsic value based upon some as yet unknown future set of cash flows discounted at an appropriate rate that equals an assets true value (absolute value) which can then be compared to its current market price to determine whether it is undervalued or overvalued.

This is still a developing thought, but one I hope to explore a little more in the future.

Likewise, modern finance (Modern Portfolio Theory, Efficient Markets, CAPM) may be equated with the philosophy trends of the enlightenment (especially Hume's rationalism), and recent developments in finance practice (HFT, quantification, algos) may be equated with quantum physics or existentialism.