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Traders at the New York Stock Exchange. Trend-following quantitative funds are cutting US equity positions. Image Credit: Reuters

Most equity fund managers worldwide would often admit that the struggle they face since the beginning of time is to get their funds to consistently beat market benchmarks.

What a lot of them went on to do as a result is get onto what was then a rising star – Quant funds, and their winning feature was the use of analytics to bet on various market factors.

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Particularly over the past decade, investors have been fleeing fundamentally driven actively managed funds for algorithm-driven Quant funds.

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So, particularly over the past decade, investors have been fleeing fundamentally driven actively managed funds for algorithm-driven Quant funds, which exploit stock characteristics—such as value and price momentum—in the pursuit of higher returns at a lower cost.

What is a Quant fund?
A Quant fund is simply an investment fund that selects assets or securities by utilizing the capabilities of advanced quantitative analysis. Quantitative funds rely on high-powered computers, vast data sets and algorithms to systematically exploit patterns in securities prices. Their success has led to a multitude of copycats and many traditional investment groups to try to imitate their techniques.

Basically, Quant fund managers seek talented individuals with accredited academic degrees and highly technical experience in mathematics and programming.

Quant funds are often known to be some of the most innovative and highly technical offerings in the investment universe.

Quant funds exploit stock characteristics—such as value and price momentum—in the pursuit of higher returns at a lower cost.

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For those investing in the long term, opinion among fund managers, on how often one should monitor the portfolio, varies from monthly to quarterly. Image Credit: Gulf News

‘Black Box’ of fund trading

Quantitative strategies are often referred to as a ‘Black Box’ due to the high level of secrecy surrounding the algorithms they use.

The popularity of quantitative analysis within funds has risen due in part to the rising availability of market data.

Quant funds utilise state of the art technology, but the use of quantitative analysis dates back eight decades.

Although Quant funds were once the fund industries’ treasured gem, they have been struggling to outperform, and have been bleeding billions of dollars in assets, since the beginning of 2018.

A bet on a value-stock comeback might have dragged down Quant funds' performance and as the market turned rockier, traditional stock-picking fund managers have outshined their Quant peers.

Although Quant funds were once the fund industries’ treasured gem, they have been struggling to outperform, and have been bleeding billions of dollars in assets, since the beginning of 2018.

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Credit Suisse estimates that Quant funds as a whole have nearly halved the size of their positions since the beginning of March this year, and that the average quant fund has lost 14 per cent this year - But this decline is largely attributed to the rapid spread of coronavirus ravaging the markets.

So to summarise, many believe that unbiased stock picking by machines is the future of investment. However, returns from these funds have been a mixed bag.

2020 - a bad year for Quant funds!
Credit Suisse estimates that Quant funds as a whole have nearly halved the size of their positions since the beginning of March this year, and that the average quant fund has lost 14 per cent this year

Now let’s weigh quant funds with managed funds and see it which of the two is preferred among investors and why.

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Understanding managed funds

A managed fund is an investment fund that is managed professionally by an expert fund manager who invests in a variety of investments.

The actual type and mix of investments within a managed fund depends on a predetermined mandate communicated by the fund manager.

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With managed funds, your money is pooled together with that of other investors to create a single fund that provides significant investor benefits, which include an instant increase in buying strength.

Managed funds versus Quant funds
How it fares compared with Quant funds is that human managers earn their stripes by demonstrating a better understanding of fundamentals, or through superior intuition, both factors developed through years of learning and proven objectively through bottom-line alpha. (Excess return of an investment relative to the return of a benchmark index is the investment's alpha.)

As we touched upon earlier, artificial intelligence-driven funds are based on analysing large amounts of data in real time and then deriving insights and subsequent investment decisions.

What this does is introduce new variables into ranking criteria, such as which fund has the fastest computing power, or petabytes of data access.

The star coder may supersede the star trader as funds gain a competitive advantage from having a superior machine learning rule written by data scientists in the background.

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Fund managers are shifting focus to a portfolio which is a mixture of corporate bonds, sovereign dollar bonds, government dollar debt and sovereign local currency bonds and equities in emerging markets. Image Credit: Supplied

Quant funds fall behind actively-managed funds— multi-cap and large-and-mid-cap—as well despite having slightly lower expense ratios.

Popular examples of quant funds

Global hedge fund DE Shaw is considered the most popular among quant fund investors, highly rated according to Wall Street Oasis (WSO).

Two Sigma Investments, which was formed by former senior DE Shaw executives, is a pure quant fund and is also considered widely popular, along with AQR and Point 72.

Quant funds losing its shine!
Although Quant funds — computer-driven strategies managed by Vanguard and other big firms — were originally thought to outsmart human minds and transform investing, now, however, as their performance plunges, they are losing billions of dollars amid their worst outflow in years. That represents a huge blow for an industry that managed at least $1 (Dh3.68) trillion.

The reality of quantitative investing worldwide is Vanguard’s quant fund went down 4 per cent, versus S&P 500’s 12 per cent gain in 2019.

Additionally funds like Neuberger Berman, Columbia Threadneedle and others had shut down their quant funds after worst outflow in 13 years.

Funds like Neuberger Berman, Columbia Threadneedle had shut down their Quant funds after worst outflow in 13 years.

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As of now, in India there are only three quant funds, including Tata Quant.

In the last six months, DSP Quant Fund has given an annualised return of 16 per cent compared to 7.96 per cent from the benchmark, the S&P BSE 200 TRI, just before the virus-related worries began in January. The fund was launched in June 2019 and is yet to complete a year.

Nippon India Quant, which was launched in February 2005, has given a return of 8.69 per cent over seven years compared to 12.43 per cent from the benchmark, according to data from Value Research. It has not been able to beat the benchmark even over five-, three- and one-year periods.

Quant Funds in India
Nippon India Quant has not been able to beat the benchmark even over five-, three- and one-year periods.

Here is how multi-cap and large-and-mid-cap have been outperforming quant funds in India.

Kotak Standard Multicap Fund, the scheme with the biggest assets under management (AUM) in the category and which tracks the same benchmark, has given 16.04 per cent over seven years.

In the short-term, six months, it gave 8.88 per cent. Mirae Asset Emerging Bluechip, the biggest scheme in the large- and mid-cap category, has seven-year returns at 22.63 per cent and six-month returns of 12.97 per cent.

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Even minor market movements can have a profound impact on a portfolio that is not diversified, fund managers say Image Credit: Supplied

Quant better than index funds and ETF?

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Quant-based mutual funds do theoretically have an edge over both index funds and ETFs (exchange-traded funds).

This is because unlike both index and ETFs, quant-based funds don’t just copy all the stocks in the index. But they have an investment philosophy of their own, based on which stocks get selected.

This investment strategy helps these funds to beat the category of index and ETFs. At the same time, quant-based funds are actively managed and also are of low costs as index funds.

Quants better than ETFs?
Unlike both index and ETFs, Quant-based funds don’t just copy all the stocks in the index. But they have an investment philosophy of their own, based on which stocks get selected. This investment strategy helps these funds to beat the category of index and ETFs.

Though the picture seems brighter for quant-based funds in theory, in practical terms, the reason they have been opted lesser than usual is because of their lackluster performance when compared to the benchmark and actively-managed small-, mid- and large-cap stock funds. So, there is your answer.

Practically, the reason Quant funds have been opted lesser than usual is because of their lackluster performance when compared to the benchmark and actively-managed small-, mid- and large-cap stock funds.

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How can one go about investing in exchange-traded fund (ETF)?
Image Credit: Shutterstock

Who prefers Quant over managed funds?

According to veteran investors, Quant funds make sense for savvy investors.

Because they use highly specialized and sophisticated strategies, only investors who understand stock valuation methods, different stock picking styles, the behaviour of markets in different cycles and derivatives, are advised to look at quant funds.

How much should be allocated to Quant funds?
At best, advisers recommend experienced investors allocate 5 per cent of their equity portfolio to three-four such theme- or strategy-based funds.

Where Quants went wrong?

Quants - investment managers that pursue a quantitative approach to equity portfolio management – effectively collapsed well before the market turmoil that was triggered by the 2007 sub-prime crisis.

Quants - investment managers that pursue a quantitative approach to equity portfolio management – effectively collapsed well before the market turmoil that was triggered by the 2007 sub-prime crisis.

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Investors are keeping near-record levels of cash. The latest Bank of America Merrill Lynch survey of global fund managers found cash made up 5.5 per cent of portfolios. Image Credit: Bloomberg
Rise and fall of Quant funds
Here is the conclusions of a study based on survey responses from 31 asset managers, and interviews with 12 asset managers and eight investment consultants and credit rating agencies in the US and Europe.

The main selling-point of Quant funds were – through the use of complex algorithms - it being unique in its approach to investing.

But what the study found was performance of many quantitatively managed funds deteriorated due to rising correlations, style rotation, and ‘herding' - the fact that there are now more active quantitative managers using the same data and similar models.

Herding - the tendency to copy what everyone else is doing - was seen as a problem.

"Everyone in the quant industry is using the same factors," one participant in the study remarks. "When you need to unwind there is no one to take the trade."

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The need then rose to identify new or unique factors.

Quant managers must develop conceptual work that is unique - that is, work that cannot be copied by competitors.

Quant managers need an ‘informational edge'!
A key requirement, the survey finds, is better information. The paradox of quant management is that managers necessarily rely on the same set of data, thereby losing their informational edge.

Quantitative equity managers also face an uphill task persuading clients that they are not ‘herding'.

The study also noted that hedge funds are seen as the main culprits for the heavy losses of quantitative equity funds a decade ago.

Quantitative equity managers also face an uphill task persuading clients that they are not ‘herding'.

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Obsolete in times of crisis

Computer-powered “quantitative”, or quant, investors and high-frequency traders – which were once wreaking havoc on markets and rendering obsolete old-fashioned analysis and common sense, has historically been proven to be obsolete in times of crisis.

Volatility-sensitive quantitative strategies were identified as the primary culprits in the 2015 market crash.

Many investors and analysts blamed algorithmic strategies that automatically adjust their market exposure according to volatility for aggravating the 2015 crash.

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An electronic display in Tokyo shows the stark reality of major stock market crashes. Picture used for illustrative purposes. Image Credit: AP

How they essentially work is – when markets are calm they buy, and when turbulence spikes they sell.

This has been a successful strategy over time. But it leaves the funds vulnerable to abrupt reversals — such as the market tumble February 2018 — and means they can accentuate turbulence by selling when markets are already sliding.

How algorithm-based trading essentially worked is – when markets are calm they buy, and when turbulence spikes they sell.

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So as of now, market behavior, a sum total of the behavior of market participants, is evidently still beyond algorithms and it is now an accepted fact that there are too many surprise elements that affect price discovery that can’t be pinned down with mathematical equations.