Why Macquarie's quant guru says human traders are here to stay

While market crashes usually send the quantitative investing community into hiding for years, the models seemed to have held their own this time.

There's no sign that the migration of capital into well designed formulaic investment strategies is slowing, particularly as institutions search for lower-cost investing solutions.

It is why the likes of Thompson, a trained engineer, are rising to prominence in the investing world.

Quarries to Macquarie

Thompson comes from a family of cattle farmers, and came to the city from Bathurst, in country NSW, to study engineering.

He worked for various small engineering firms and ended up working in hard rock quarries near Canberra. But he had got the taste of financial markets and was keen to switch careers.

"The content and the environment was a little bit dry," Thompson says of his early days as an engineer. So he studied a masters degree in applied finance before taking a job in funds administration at AMP.

In 2001, his journey from the quarry to Macquarie was complete when he joined the firm's funds management arm.

At that stage, Macquarie's asset management business was in its relative infancy – accounting for just 1 per cent of the group's earnings. Today, that contribution to Macquarie's net profit is more than 40 per cent.

The systematic team too was small, but had been in place since 1992 and had a strong track record.

Thompson was appointed co-head of systematic investments in 2014, at a time when the interest in that form of investing was gathering pace.

We have moved on from the idea that you need to be a stock picker in small caps, because there's not enough data.

— Scot Thompson

Today, the systematic unit manages $20 billion of assets for Australian and global clients.

The public manager roster of the $162 billion Future Fund is a testament to how institutions are placing greater faith in systemic investing: Macquarie has the sole Australian equities mandate.

Thompson says Macquarie's systematic strategies performed well during the COVID-19-induced sell-off, and the broader faith in quantitative investing is growing.

"Generally people are feeling more comfortable that technology can extend into asset management," he says. "The quality of the data, the size of the data sets and the computing power has grown."

The rise of quant investing is coming at the expense of traditional stock pickers who are finding it hard to justify their value relative to lower-cost alternatives.

Small cap opportunities

The general consensus is that it is becoming harder for stock pickers to gain an edge when investing in well covered large cap stocks, but active managers can still hold their own in the smaller end of the market.

Thompson, however, says that as the quality and proliferation of data increases, small caps are the next frontier for quants.

"We have moved on from the idea that you need to be a stock picker in small caps, because there's not enough data," he says.

"The small cap universe is big. If we can look at the whole universe and find where the opportunities are, it opens up [that part of the market]. The data and information is getting better and better."

Thompson is not dismissive of active managers. They do add value, he says, but it's important for investors to understand what they are buying when they appoint an active fund.

"Active managers are giving you exposure to something that they are – it is their biases and characteristics – not necessarily the return."

It is important that the investor and the fund manager are "on the same page", so they're comfortable with any investment decision, even if it doesn't work.

The funds management industry has been under siege for several years as large institutions have lowered the fees they are willing to pay to fund managers.

Part of the reason is that these institutions, such as superannuation funds, are competing with each other on costs.

The consequence is that more are opting for the lowest-cost solution – which tends to be the traditional market capitalisation weighted indices.

But the problem, Thompson says, is that institutions end up having the same exposures and therefore lose their differentiation. That is where the interest in systematic investing is on the rise, he says.

As institutions seek to gain an edge over their competitors, they are asking for customised indices that have, for instance, equal weights to stocks or limits imposed on sector exposures.

The behaviour of value has always been there. People want to buy something that is cheap. But how do you assess that value?

— Scot Thompson

“There are different ways of constructing exposure so you spread your risk across the spectrum," he says.

Underlying a systematic investing strategy is data. While Thompson says data is getting better and becoming more abundant, they have to stay on top of their game.

One example is the use of earnings forecasts from analysts, which has historically tended to be a reliable signal.

But the pool of research analysts providing forecasts is shrinking. That has led to the use of other enhanced measures of earnings certainty, such as signals from the options and credit market spreads.

One of the biggest challenges facing Thompson and his team is understanding how measures of value or cheapness have evolved.

In a market dominated by big industrials with comparable levels of capital expenditure, a price to earnings ratio was "probably spot on" as a measure of value.

But in today's market, value resides in human capital, and price to earnings or book value is arguably a less relevant measure.

"The behaviour of value has always been there. People want to buy something that is cheap," he says. "But how do you assess that value? That is what is changing and where everyone needs to evolve."

Another challenge facing quants is coming to terms with this prolonged period of easy money, which Thompson says is also forcing a reconsideration of measures of value.

"It is almost riskless investing because you have someone behind you printing money."

Thompson is an engineer running systematic strategies, so he has no obvious bias. But he's also of the view that there is a glaring disconnect in markets at the moment.

“There is a dislocation between fundamentals and market pricing. There is no clear path to growth in the short term, but the market is charging [forward].

"Investors are still playing but the risk of the correction is still growing."

Work from home revolution

So while he is trying to make sense of market valuations in the post-COVID-19 world, Thompson is also grappling with the operational changes.

The enduring legacy of the pandemic will be a change in work habits. Managing $20 billion of funds via quantitative strategies would not typically be considered an endeavour that could or should be operated remotely.

But Thompson says the lockdown has demonstrated that "people can work from home and it can be a good experience".

"I was pleasantly surprised by the length everyone went to to make sure it worked," he adds.

Thompson is now dealing with colleagues from around the world – whether they are in Luxembourg, New York or the United Kingdom, and the electronic communication has been seamless.

"There was a stigma from working from home, but the quality of tools have definitely changed that," he says.

Remote working isn't all upside, however. One of the challenges, he says, is integrating new members into the team when they cannot meet or interact in person.

But he is confident Macquarie's entrepreneurial culture will prevail.

"The team around me has been really engaged and drives me to want to come to work every day," he says.

Of course, in 2020, that statement has to be taken metaphorically.