Inside the Black Box: The Simple Truth About Quantitative Trading

6.4. HOW QUANTS CHOOSE A PORTFOLIO CONSTRUCTION MODEL

I have observed that the significant majority of quants using rule-based allocation systems seem to take an "intrinsic" alpha approach (i.e., they forecast individual instruments rather than forecasting instruments relative to each other). Most, but not all, of these are actually futures traders. Meanwhile, quants utilizing optimizers tend to be focused on a "relative" alpha approach, most typically found among equity market neutral strategies. There is no obvious reason for the difference in the preferred portfolio construction approach for relative and intrinsic traders. However, it is likely that quants that use relative alpha strategies already believe implicitly in the stability of the relationships among their instruments. After all, in a relative alpha paradigm, the forecast for a given instrument is as much a function of that instrument's behavior as it is about the behavior of the other instruments, to which the first is being compared. If these relationships are unstable, the strategy is doomed to start with, because its first premise is that certain comparisons can be made reliably. If the relationships are stable, however, it is entirely logical and consistent that the quant can rely on them for portfolio construction as well.

Meanwhile, if a quant takes an intrinsic alpha approach, he is making an implicit statement that his portfolio is largely made up of a series of independent bets, so relying on a correlation ...