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5 flaws of black-box investing

September 19, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

Investment tips and black-box investing

Quantitative investment formulas, often referred to as black-box investing, have been around for a long time. However, advances in data gathering and artificial intelligence are pushing some of these techniques to new heights of complexity. The question is, does that added complexity bring greater effectiveness?

There are arguments to be made for and against black-box investing. It can play a useful role in your portfolio, but you should understand its limitations. After all, no degree of mathematical precision can guarantee that a strategy will add value.

Why investors choose black-box investing

Here are some of the points that black-box investing has in its favor:

1. Investment discipline

An automated investment approach is one way to take human error and emotion out of investing. Human money managers are prone to straying away from their disciplines. Fear and greed influence decisions. In particular, professional money managers start to rationalize making exceptions when they are under the gun for poor performance. Following an automated formula should remove the problems that result from human nature.

2. A degree of predictability

A quantitative approach will tend to be very pure in terms of investment style. It might have a particular bias, such as towards growth or value investing. But, an analysis of the formula or the principles behind it should make it fairly clear what that bias is. Style purity brings some predictability to the results, and this in turn helps an investor construct an investment program in which different managers play clear, complementary roles.

3. Low management costs

Having a computer picking stocks is much cheaper than a team of analysts researching companies one by one. Additionally, the money management firm should be able to pass this cost savings on to its clients.

4. A high-speed way of identifying inefficiencies

Some strategies work by exploiting arbitrage opportunities created by small market inefficiencies - pricing anomalies in which market valuations become temporarily out of step with those of the same or similar securities.

These anomalies are small and generally short-lived, so the only way to reliably make money by exploiting this kind of thing is to spot them quickly and trade in high volume. Computers are much better suited than human investors to identifying these opportunities and executing decisions quickly enough.

5 ways black-box investing is flawed

Of course, if successful investing could be reduced to a formula, everybody would be following it by now. In actual fact, trying to invest this way does have its complications:

1. Back-fitting data can be deceiving

Promoters of black-box investing often test their formulas with historical data to see how they would have performed. This type of backward-looking test is called a back fit, and the results can be somewhat deceiving. With hindsight, it is not too difficult to devise a formula which would have been successful in the past, but that track record is no guarantee of how the strategy will perform once it is up and running in real time.

2. Conditions change

One of the reasons why back fits do not always carry over to the future is that conditions change. Artificial intelligence techniques are being used to create approaches that can adapt to changing conditions, but those adaptations are still akin to human experience. No matter how much experience is accumulated, the combination of conditions shaping markets is always going to be a little different from what was observed in the past.

3. Investors flock to successful approaches

Another reason formulaic investing has a hard time duplicating past success is that investors tend to jump on the bandwagon of any successful approach. This popularity starts to remove the opportunity from markets by making valuations less attractive.

4. Lack of transparency

Black-box investment managers have a dilemma: They need to describe their approaches without providing so much detail that their clients could simply replicate the approach for themselves. This means that those clients may not know everything about how their money is invested, and the unknown sometimes contains unpleasant surprises.

5. Blind obedience may be dangerous

Long-Term Capital Management was a high-flying hedge fund that went bust quickly and spectacularly in the late 1990s. Its proprietors had so much faith in its investment approach that they applied a high degree of leverage to it. That level of blind faith leaves little room for error.

There is certainly a place for quantitative methods in investing. How heavily to rely on those methods, though, is a tricky question. Taking the possibility of human error out of investing is a tempting proposition. But don't forget that ultimately even black box investors rely on human judgement to devise the right investment formula.

More from MoneyRates.com:

Protect your portfolio: 3 big factors of investment risk

5 misconceptions about robo-advisors for retirement savings

How to deal with low bond yields: 4 alternative investments

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