The Quant AdvantageREDUCE HUMAN bias, error and emotion RESTRICT CHOICE OF STOCKS based on the model (algorithm) CONSISTENCY in strategy
ADDITIONAL ASSET ALLOCATION option for investors
CONSISTENT AND DISCIPLINED investment process, offering superior risk control
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A little over a decade ago, the reigning chess champion Garry Kasparov was trounced in a match that lasted just an hour. The winner of that match was Deep Blue, a chessplaying computer from IBM. If a computer can match the wits of one of the greatest chess players in the world, it should surely be able to beat a stock market benchmark.
And it can. Stock selection is a science (although there’s a school of thought that believes it’s an art) that can be captured in a computer program.
Quant funds are mutual funds that select stocks in their portfolio on the basis of quantitative analysis. In actively managed funds, buy and sell calls are taken by the fund manager. By contrast, in quant funds, a mathematical formula identifies buy and sell calls as set out in the fund’s objective. Quant fund managers generally design these mathematical methods.
The exact strategy used is proprietary (see box: Strategy Snapshots) and funds spend a lot of time and money developing their own models, which they guard very closely. Before quant funds are opened for subscription, they are rigorously back-tested. “Quant models use extensive back testing of past data to create their investment algorithms,” says Rajiv Shastri, head of business development and strategic initiatives, Lotus India Mutual Fund. The model is developed on the basis of mathematical and statistical parameters. This also means that fund managers’ biases and sentiment can be almost eliminated.
Quant funds have been around since the 1970s, but have only recently entered India. In November 2007, the country’s first quant fund (Lotus India’s AGILE fund) was launched. Other fund houses followed suit. In recent times, Reliance Mutual Fund has merged its Sensex/Nifty Index Fund and converted it into a quant fund called Reliance Quant Plus Fund.
Prudential ICICI AMC has launched its Focused Equity Fund, a blend of quant and actively managed fund. Benchmark AMC has filed an offer document with Sebi for Benchmark India Value and Momentum Quant Fund that will invest in securities based on a quantitative stock selection model provided by Citigroup First Investment Management.
Strategy Snapshots of Two Funds |
Lotus AGILE
The stock universe is derived using the following parameters
MARKET CAPITALISATION OF STOCK chosen should not be less than the market capitalisation of the last stock of S&P CNX Nifty
FLOATING STOCK OF THE COMPANY should not be less than the least floating stock of the Nifty. Floating stock is stock which is not held by the promoter associate entities of such companies
STOCK SHOULD HAVE A PRICE HISTORY of at least one year before date of investment; the industry represented by the stock should be present in the composition of the Nifty
| ICICI Focused Equity
Besides strategy stated in offer document, following rules apply:
STOCK UNIVERSE Fund portfolio will comprise Top 200 companies in market capitalisation listed on NSE. Nearly 80% of portfolio is intended to be invested in a maximum of 20 large-cap stocks
STOCK ALLOCATION Subject to liquidity, market volatility and the size of the portfolio, the fund reserves the right to increase the number of companies to more than 20
SECTOR ALLOCATION Bottom-up stock picking. Allocation will be dynamic and could be concentrated based on theme or momentum |
There are several models upon which quant funds are based. For instance, the Lotus Agile fund model selects 11 stocks based on their price and volumes from within the Nifty and maintains a 9% allocation to each stock. The portfolio is thus rebalanced automatically each month. ICICI Focused Equity looks at a basket of 20 stocks from within the BSE 100. Says Devan Sangoi, senior fund manager, ICICI Prudential AMC: “The focused fund will look at a combination of 20 large-cap stocks, as these are less volatile compared to mid- and small-cap stocks.” This large-cap bias should make the fund resilient to short-term market turbulence.
Why do quant funds matter to retail investors? The fund model sounds promising, but can stock selection be safely left to a computer, no matter how robust? Since its inception in 2007, the Lotus Agile Fund has lost 21% compared with its benchmark Nifty’s loss of 12.7%.
That’s hardly encouraging. However, as a market watcher points out, it was the fund that performed badly, not the model. What most quant funds promise is to achieve alpha, a measure of a fund’s performance against its benchmark index. (Alpha is a measure of performance on a riskadjusted basis. Alpha takes the volatility or price risk of a mutual fund and compares its risk-adjusted performance to its benchmark index. The excess return of the fund relative to the benchmark index is a fund’s alpha.) “Quants take about half as much risk as non-quants and do not lose as much in the down years,” says Shastri.
The most obvious advantage of the quant model is that it can examine a much larger universe of stocks than human analysts. But this is something that is yet to take place. The four quant funds available consider stocks that are anyway from the better performing list. But once this model matures, it is possible some quant models will invest in more than 20 stocks from the 4,000-odd listed stocks on BSE based on fundamentals, valuation, momentum and risk. The potential of quant funds exists, but investors need to evolve for that to happen.
So, if you invest in a quant fund, how much of your portfolio should you allocate? According to experts, a mix of 60% exposure to diversified equity, 20% index and ETFs and another 20% to quant funds should be the ideal mix for an equity-based mutual fund portfolio. “The quant strategy will typically work if investors have a timeframe of at least one year,” says Shastri.
