I found the following article compelling:

http://news.morningstar.com/articlenet/SubmissionsArticle.aspx?submissionid=134195.xml

Here is a quick summary in the author’s words:

Gotham Asset Management managing partner and Columbia professor Joel Greenblatt explains why investors who ‘self-managed’ his Magic Formula using pre-approved stocks underperformed the professionally managed systematic accounts.

 

The article highlights an important lesson for those who attempt to implement a dangerous blend of quant and fundamental, or “quantamental” investing.

One of the beauties of quantitative investing is the complete removal of human emotion from the investment process.

One of the beauties of fundamental investing is the complete human involvement in the investment process.

So how can the blend of the two investment methods give birth to something so ugly?

 

Well, let’s work on a live example. Here are some results from a profit and value screen off Turnkey Analyst:

I’ve highlighted some of the names that look scary:

RIMM–seriously, who the hell buys Blackberries anymore???

RSH–a business model that sells cheap electronic stuff from China with no economies of scale edge like WMT?

PNG–natural gas storage? Gotta love the flat natural gas curve and prices that are cheap as dirt as far as the eye can see.

SHLD–Poor Eddie Lampert

GME–Chanos hates it. XBOX Live sells games via download. Streaming is all the rage. Ebay clears a huge part of the market. Yuck.

So, if I wasn’t a quant I would almost certainly sh&$-can all the names above because it is simply “common-sense” that those names are like grasping on to a falling knife. Right?

Well, the reality is that I would in all likelihood be 100% incorrect, and the evidence from Greenblatt in consistent with this conjecture. The beauty of quant is you don’t have to actually look at the group of nasty/ugly companies you are about to purchase–you just buy them. And when you buy them, you win big–at least historically. For example, simply purchasing a basket of stocks ranked highest on profit and value over the past 40 years can earn you a return in the 15-20% range depending on the liquidity range you decide to trade in. But you know what? You would have been holding some very ugly/nasty names along the way.

So ask yourself the question: Can I really be a quant? Or am I destined to always want to “know” whats in my portfolio and meddle with the models?

If you like to meddle in the results, quant isn’t for you. It is probably better than you go all-in on fundamental value and try and learn a company inside out. This is a high-risk (if you’re doing it right you’ll be concentrated), high-reward game (if you’re doing it right you’ll win more often than you lose). Quant is a lower-risk, middle-level reward game, but it requires discipline and an ability to keep your hands out of the cookie jar.