Quant Funds: Worth Adding To Your Investment Portfolio?

September 1, 2021 Mutual Fund

The past few years have been full of technological advancement in almost every field. The mutual fund industry is among those that have quickly adapted to meet the demands of the new world. Mutual fund houses use technology in its various processes such as execution of transaction, servicing customer requests, etc. The crucial task of selecting and monitoring the stocks in the portfolio, however, still rests on the fund managers’ shoulders.

But could automation soon take over this task?

Case in point is Quant Funds that rely on automated programs to make investment decisions. Stock selection of these schemes depend on the pre-defined computer-based quantitative model.

In the last couple of years, several fund houses have launched Quant Funds. Nippon India Quant Fund launched in 2008, is the oldest quant fund in India followed by DSP Quant Fund in 2019, Tata Quant Fund in early 2020, and ICICI Pru Quant Fund in late 2020. Quant Quantamental Fund and Axis Quant Fund were both launched in the first half of 2021.

How does Quant Fund work?

A Quant Fund’s model analyses inter-alia, the following factors to pick the most suitable stocks for the portfolio:

1. Fundamental factors such as Return on Equity, P/E Ratio, P/B Ratio, Cash flow, Dividend, Earnings growth, etc.
2. Technical indicators such as 52-week high, 52-week low, Relative Strength Index, Moving Average Convergence Divergence, etc.

By relying on the quantitative model, Quant Funds aim to eliminate human intervention. This can be beneficial because at times fund managers’ assumptions, sentiments, intuitions, and impulses can affect investment decisions. Rebalancing of the portfolio happens at regular intervals based on the metrics of the model.

Another advantage of investing in Quant Funds is that even if a fund manager/s is no longer a part of the team, there would not be any reason to worry about the scheme’s performance.

Every fund follows its own in-house proprietary model to select and eliminate stocks, analyse various factors, and to assign weightage in each of the selected stock. These funds have the flexibility to invest across market capitalisation range, sectors, and investment style. However, most funds maintain a large-cap biased portfolio along with significant allocation to mid-caps.

Quant Funds are not entirely passive in its investment approach. Fund managers of quant funds play a crucial role in periodically assessing the model and determining any need for change in parameters. They also play a part in rebalancing the portfolio to implement changes suggested by the model. Additionally, they can undertake unscheduled rebalancing to factor in any adverse news, corporate action, rating downgrade, etc.

Since the fund manager’s involvement is less, Quant Funds charge lower expense ratio compared to actively managed funds, though higher than passively managed funds.

Do Quant Funds guarantee market-beating returns?

Investing in quant funds does not guarantee market-beating returns. Its success depends on the efficiency and quality of fund management as well as robustness of the model developed by them.

Quant funds are modelled based on past trends which are not an indicator of future performance. Besides, most Quant Funds in India were only recently launched. Their performance record till now has not been superior when compared to actively managed funds.

Table: Performance record of Quant Funds

Data as on August 30, 2021
(Source: ACE MF) 

Quant based models work strictly on the pre-defined criteria and parameters for stock picking. Sometimes, the model may eliminate a high potential stock if it does not fit into the pre-defined criteria.

Moreover, the model might miss out on qualitative data such as management quality, internal processes, and other intangible and non-quantifiable assets. On the other hand, the fund managers of an actively managed scheme through their expertise, research, experience, and instinct can capture such nuances.

Equity markets are dynamic in nature. So, there is a risk that the quant-model may take time to capture new trends in the equity market. This time-lag in adapting the new developments could result in delay in action from the fund manager and may impact the returns.

Quant based funds seek to eliminate human intervention in the stock screening/selection process, in order to reduce the ill effects of various behavioural biases. However, the model itself is developed by humans and may be prone to error and judgemental bias.

Many expect that the quant-based models will be the future of investing as AI technology develops further. However, Quant funds are currently at a nascent stage in India and it may take time to perfect the model. There are only few existing funds that follow the quant-based approach to investing, of which only one fund has a long-term track record. This is not enough to judge the potential this investment strategy has to offer.

What should investors do?

Quant funds are only suitable for long term investors as it may take time for the model’s strategy to pay off in full. If you understand the underlying risk, Quant Funds can form a small part of your portfolio where the total holding does not exceed 10-15%.

As we can see in the table above actively managed diversified equity funds have done well to generate reasonable alpha for investors. Therefore, to earn optimal risk-adjusted returns I suggest investing in a well-diversified portfolio of actively managed equity funds by following the ‘Core & Satellite’ approach.

The term ‘Core’ applies to the more stable, long-term holdings of the portfolio, while the term ‘Satellite’ applies to the strategic portion that would help push up the overall returns of the portfolio, across market conditions.

The ‘Core’ holding should comprise around 65%-70% of your equity mutual fund portfolio and consist of a Large-cap Fund, Flexi-cap Fund, and Value Fund/Contra Fund. The ‘Satellite’ holdings of the portfolio can be around 30%-35%, comprising of a Mid-cap Fund and an Aggressive Hybrid Fund.

By selecting schemes wisely, structuring the portfolio between the Core and Satellite portions, you will be able to add stability to the portfolio and at the same time strategically boost your portfolio returns.

This article first appeared on PersonalFN here