Inside the Black Box

In Search of Alpha

Quantitative trading strategies employ computer technology and mathematical models to identify and take advantage of trading opportunities in the pursuit of alpha, which is “returns that are independent of the direction of any market in the long run.” To achieve alpha, traders of quantitative strategies – called “quants” – must find ways to achieve net returns over and above what investors would have received if they had simply bought an index of stocks.

Traditional investment managers typically use personal discretion to make these decisions. What separates quants from those “discretionary traders” is how quants invent and execute their strategies, not necessarily the strategies themselves. Quants use computers and algorithms; discretionary traders make “decisions driven by emotion, indiscipline, passion, greed and fear.”

Investors, managers and traders who rely on discretion to implement strategies are prone to using mental shortcuts or behavioral biases, such as holding on to falling stocks. In quantitative trading, computers dispassionately execute commands based on vital, front-end human input – in the form of thorough research, software...