Beyond value investing: What is evidence-based investing?

“We live in a universe predicated on randomness and luck”

–The Biggest Bluff by Maria Konnikova

At the heart of how most investors approach investing, is stock picking using fundamental analysis.

As for the record of stock picking, here is an insightful Q&A about its “terrible track record.”

• Active management is bad. Most investors are better served owning low-cost index funds like the S&P 500; stock pickers can’t identify underpriced stocks with any regularity.
• What about Buffett’s success? In the past, executing that strategy — buying high quality stocks that are cheap — used to require a lot of work. But today, you can replicate a lot of this with an ETF at a very low price. You don’t need to hire Warren Buffett.
• What about thematic or factor investment styles? These factors can now be replicated cheaply, and the more people pile into them, the less effective they will become. (See also this WSJ article about the concentrated nature of thematic ETFs.)
• Past performance has no predictive value. The big mistake everyone makes is they assume the future will look like the past. It doesn’t. Past performance of active managers does not indicate future performance.

Stock picking and fundamental analysis, championed by Benjamin Graham and Graham’s most famous protege, Warren Buffett, continue to dominate most investors’ mindset, ever since Graham wrote his value investing framework in Security Analysis and The Intelligent Investor.

Beyond fundamentals investing, is there any other investment framework?

Surely the brightest minds in academia and billion-dollar fund practitioners would have come up with investment philosophies beyond fundamentals.

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The Rise of Evidence-Based Investing

Evidence-based investing, aka technical analysis, is the other side of the coin to fundamental analysis. (See this Q&A on evidence-based investing.)

For value investors, fundamentals lead, and prices follow, albeit noisily. However, for technical investors, prices lead, perhaps even driving fundamentals, but fundamentals are not the core driver of stock movements.

Source: Alpha Architect

Examples of evidence-based investing approaches include factors, statistical arbitrage, momentum, and trend following.

Though it is often the case that investors are staunch converts of either one of the two camps – Team Fundamentals or Team Evidence – this primer does an excellent job of explaining why both approaches work and can happily co-exist:

An ever-growing body of academic research formalizes the evidence that fundamental strategies (e.g. value and quality) and evidence-based/technical strategies (e.g. momentum and trend-following) both seem to work.

An evidence-based investor will conclude that fundamental and technical analysis strategies can work because they are two sides of the same coin.

Case in point: AQR, a leading quant firm, applies evidence-based strategies to, amongst other approaches, value investing.

In terms of semantics, it is unfortunate that evidence-based investing infers judgement: “Are you suggesting that fundamental investors are less thoughtful, less intellectual, less data-driven in their rigorous pursuit?”

Perhaps more contentiously, evidence-based investors might view fundamental investors as storytellers: Taking a number from today and multiplying it by a story about tomorrow; albeit using data about P/E ratios, price-to-book-value ratios, sales or profits growth rates, dividend yields, and interest rates. (Think Tesla, to the moon.)

In contrast, evidence-based investors lean into probabilities and statistics.

Think of waves on a beach: At any given moment, it is impossible to predict where each individual, random wave might land. However, high tide and low tide timings are reliably predictable.

Apply a similar concept to trading the market: At the macro level, evidence-based investors trade statistically significant patterns using technical strategies (e.g. statistical arbitrage, momentum, or trend following strategies, etc.) to capture alpha – herein lies the “evidence” component of the approach that makes decisions based on things that are known to be factually true.

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Notwithstanding the throwing shade at Team Fundamentals in this post, experience informs us that changing an investor’s worldview is very hard: Investors buy what they know and find safety in numbers; fundamental strategies are appealing and accessible, requiring minimal effort for the investor to fathom and to open their checkbooks. (See this astute post about the fine line that we all walk between the perils and inevitability of forecasting.)

Team Evidence, on the other hand, faces the uphill challenge of investor education and continues to rack up a lower share of capital allocation.

As an evidence-based, quant shop, Alphalytics is bias to trading the market using statistically-driven models that have a win rate that beats the market (in the long run), as opposed to using fundamentals to forecast the market. Instead of placing bets on where the market is headed, we analyze reliable, repeatable patterns – the “highs and lows” of the market – as evidence to inform us of what to buy and what to sell.

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