I have spent most of my working life trading and creating strategies for trading groups. At the beginning of my career, quant trading was dominated by arbitrage strategies that today we would consider quite slow and simplistic. Despite that, the strategies were quite profitable. Markets have become much faster and more efficient, and strategies have evolved to identify and exploit opportunities that are available for a few milliseconds and then disappear. The strategies that you will create don't have to be perfect. Actually, perfect doesn't exist in the trading world. They just need to be as good or better than the ones that your competitors will be using. First, we will discuss the differences between trading and investing. We will also identify the main strategy categories in the Quant Universe and then gain an understanding of how each component fits into a quant strategy. Lastly, we will point out the strong points and weak points of typical quant strategies. In this section, we will explore the design and implementation of quantitative strategies in trading. We will talk about the different parts of the Quant Universe and then explore the main types of quantitative trading strategies. First, let's talk about trading versus investing. Financial sector firms are usually designated as either buy side or sell side. Buy side refers to firms whose primary business is investing and advising. This group includes asset managers such as private equity, mutual funds, life insurance companies, pension funds, and quantitative trading firms such as hedge funds. Sell side refers to banks and broker dealers that sell investments and services to asset managers and hedge funds and that also provide market-making services. That means they act as dealers in secondary markets. At investment firms, we find portfolio managers make longer-term decisions about the strategic allocation of assets and somewhat shorter-term decisions about the tactical allocations. Strategic allocation decides how much to invest in each asset category such as equities, bonds, real estate, or commodities. Tactical allocation chooses specific assets to buy or short within each category. The most common investment strategy is to buy and hold assets that had been identified as undervalued based on fundamental analysis. Portfolio managers' gains and losses are measured relative to a relevant benchmark, portfolio, or index which mirrors their strategic allocation in their portfolio. This performance is measured net of any moves in the benchmark or index. So they can only outperform if their asset choices beat a passive portfolio that mirrors the benchmark. Hedge funds on the other hand, we find traders, developers, and researchers all working together to identify and implement quantitative strategies. Their goal is to generate a positive return that is independent of overall moves in the market. This hedge return is called Alpha. The term Alpha is also widely used by portfolio managers to refer to their outperformance or return above a benchmark. This excess return seems similar to the Alpha generated by hedge funds, but there's an important difference. Portfolio manager Alpha comes from long asset holdings that are exposed to market, sector, and company risk as opposed to hedge fund Alpha which comes from a hedge strategy that has eliminated or at least attempted to minimize these risks. This is one of the key benefits of investing in a hedge strategy, especially if you're worried there'll be a sell off in the overall market. Portfolio managers use fundamental analysis to rebalance the allocations in their portfolios. Rebalancing includes changes in the strategic allocation to give undervalued asset categories a heavier weight in the portfolio. It can also include tactical reallocation, where ideally you're selling winning assets that have achieved their full target value and replacing them with undervalued assets that have the potential to help the portfolio achieve returns in excess of its benchmark. At trading firms, traders have a much shorter-term opportunistic focus. The time frame for their investments ranges from a few months to a few milliseconds. A millisecond end of this spectrum dominates over all trading volume. Traders rarely use fundamental analysis as a factor in their decisions as they consider this information to already be baked in to the market price and essentially worthless for generating Alpha. Traders instead look constantly for market behaviors and inefficiencies that will generate high-risk adjusted returns on their trading capital. Although they trade the same assets as portfolio managers, they generally ignore fundamentals and focus on other sources of mispricing. Buy-side quantitative methods include regression, prediction models, statistical arbitrage, and machine learning which we'll cover later in the course. Sell-side quantitative methods are mostly execution strategies. These are designed to reduce the market impact cost of large orders and also to capture spreads by providing liquidity through market making. Keep in mind though that buy-side firms also employ execution strategies when they execute their trading orders.
