A better theory of markets leads to better investment strategies.
Typical quantitative investment strategies start from an assumption that markets behave according to a fixed set of rules such as one finds in physics or engineering. Dr. Lo's pioneering insight was that biology—specifically evolutionary biology—provides a much more descriptive and useful model of markets. AlphaSimplex's investment philosophy—as detailed in Dr. Lo's Adaptive Markets Hypothesis—is that markets are not perfectly efficient, but they are highly adaptive and competitive. Investors experience fear and greed and can at times be overconfident or overly risk-averse, but they learn from their mistakes and adapt as they compete for economic survival. This dynamic process of innovation, competition, and natural selection yields a far richer set of implications for investment management than existing financial theories—implying, for example, that market movements are neither stable over time nor linear functions of common factors—yet is powerful enough to reconcile the apparent contradictions between the Efficient Markets Hypothesis and Behavioral Finance.
Traditional quantitative approaches such as factor-based linear models are characterized by an important weakness: the factors are often static, working well until they fail. Quantitative models are often criticized for being slow to adapt or react, and too easily surprised by sharp and non-linear market movements. AlphaSimplex has developed models that go beyond these limitations.
AlphaSimplex models incorporate new statistical techniques for identifying phase changes in investment cycles, multiple strategies designed to suit a variety of investment environments, and algorithms for dynamically weighting these multiple strategies and adapting to different markets conditions, factors, and time horizons. The Adaptive Markets Hypothesis also requires a more sophisticated approach to risk management, with analytics capable of measuring illiquidity exposure, sudden changes in regime, and dislocations such as flights-to-safety. AlphaSimplex has developed unique proprietary models and automated systems for managing portfolios of alternative and traditional investments in an integrated framework, and these tools and technologies represent a critical competitive advantage for the firm.