Inside the Black Box: The Simple Truth About Quantitative Trading

12.4. THE EDGE

In assessing a portfolio manager, including a quant, a key issue to focus on is the idea of an edge. We define an edge as that which puts the odds in favor of the portfolio manager succeeding. An edge can come from three sources, listed here in order of commonness: the investment process, a lack of competition or something structural. In investing and trading, an edge is not the same thing as a competitive edge. A trader might have absolutely no competitors, yet still manage to lose money. I've seen it more than once. An investment edge is thus more intrinsic than comparative. Still, competition does matter: A valid idea with a valid implementation might make little or no money if there is too much competition, whereas a mediocre strategy might make money if there is none. As such, one must ascertain the sustainability of a given trader's edge. The odds might be in the trader's favor today but against him tomorrow as the world changes or as competition increases, if the trader does not evolve.

An investment process edge must come from one or more of the six components of the investment process we just outlined. Too often, when asking a discretionary stock picker what his edge is, we hear him say, "Stock picking." But this is merely a description of the activity, not evidence that the trader is any good at it. One must dig further into the reason that the trader claims to have an edge in any of these activities. For quant traders, most often an investment edge comes ...