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August 31, 2020

Processing the rise of quantitative investing

SeventyFour

Big data and ever-growing computing power are transforming the financial industry. 

But how these long-run changes have shaped the industry's incentives to process and produce information isn’t well understood, according to a paper in the August issue of the American Economic Review.

Authors Maryam Farboodi and Laura Veldkamp say that as a result of more processing power, old-school investment strategies are giving way to new types of analysis that focus on trading activity instead of fundamental business characteristics. 

Traditionally, investors have poured over company business models to estimate the potential for growth. In contrast, the newer strategies try to spot arbitrage opportunities in financial markets with sophisticated algorithms.

Both approaches produce information, but the authors found they have different impacts on financial markets.

Figure 3 from their paper shows how hedge fund assets have shifted away from fundamental analysis to quantitative analysis.

 

 

Figure 3 from Farboodi and Veldkamp (2020)

 

Each series shows the assets under management per fund devoted to a type of investment strategy. The blue line shows the fundamental approach. The red-dashed line shows strategies that rely on statistical arbitrage. Funds represented by the green dashed line use a mixture of fundamental and quantitative analysis. And finally, the black line combines both the purely quantitative and mixed funds.  

The dashed lines catching up with the solid blue around 2009 shows that quantitative approaches are now just as important as fundamental analysis among hedge funds.

The authors build a detailed model to understand why this is happening and what this development means for the stability and efficiency of the financial sector.