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Source: AQR, eVestment Whiskers show maximum and minimum values, box shows the inter-quartile range, and marker is the median value. Manager returns are for U.S. Large Cap Equity managers in the eVestment database. See Disclosures for a description of the universe. Discretionary and Systematic refer to managers who have reported their primary investment approach as fundamental and quantitative in eVestment respectively. We remove managers who do not have returns over the full period shown. Manager active returns are calculated by eVestment relative to manager preferred benchmarks and are reported either gross or net of fees. For managers who report returns gross of fees, we convert the returns to net using the median fee of the universe. Time period is January 1, 2022 to December 31, 2024. Past performance does not predict future returns.

The authors in the AQR paper theorize that discretionary managers have struggled in recent years as the US stock market has become more concentrated, especially given the dominance of the Mag 7 stocks.  In fact, what their analysis discovered is that systematic strategies were actuallymore successful in delivering alpha from outside the Mag 7. These findings seem counterintuitive. The AQR authors believe these results are inherent in more diversified portfolios, writing that "a small advantage spread across many unique bets provides a quant manager with conviction, rather than relying on a concentrated 'all eggs in one basket' strategy."

Source: AQR, eVestment Manager returns are for U.S. Large Cap Equity managers in the eVestment database. See Disclosure for a description of the universe. Discretionary and Systematic refer to manager who have reported their primary investment approach as fundamental and quantitative in eVestment respectively. We remove managers who do not have returns over the full period shown. “Mag-7 exposure” is calculated based on a returns based regression of manager active returns on returns on the S&P 500 and a market neutral “Mag-7 Factor”. “Alpha controlling for Mag-7 exposure” is annualized alpha from the same regression. Time period is January 1, 2022 to December 31, 2024. Past performance does not predict future returns.

In other words, the key differences in the structure of quant versus discretionary strategies is increased diversification. A higher degree of diversification allows the quant fund to have more conviction because they are making so many small bets. Moreover, the ability to build and harness models with unique data inputs or signals can be leveraged to further improve conviction, a trend likely to become more potent with AI

It turns out discretionary strategies can also improve their conviction while staying more concentrated, which is critical as I still believe that active stock picking is a key ingredient in efficient markets and deserves consideration as part of an overall equity strategy.  For these reasons, Northern Trust continues to invest in solutions to support fundamental investing.  Our partnership with Equity Data Science (EDS) and Essentia Analytics is a manifestation of our commitment to active management.

EDS supports the integration of systematic elements into traditional stock picking, leveraging quantitative and data driven solutions to deliver a “best of both worlds” approach to fundamental equity strategies.  One of the key points made by AQR is around conviction, and EDS provides a data-driven platform to codify and evaluate conviction.

Essentia Analytics helps portfolio managers understand behavioral biases to instill more discipline into the investment process.  With better situational awareness of biases and data-driven feedback, Essentia enables an improved ex-ante decision process that more resembles that of quantitative funds.

These tools, I believe, improve conviction without increasing diversification and will keep discretionary equity strategies relevant, enabling evolution in a world with increasing reliance on data and modeling.

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