BT Insight: All you need to know about quant funds

DSP Mutual Fund has launched a new fund, DSP Quant, under which the stock selection will be done based on a predefined quantitative model with no human intervention. The new fund offer (NFO) is currently open and will close on June 3. This is not the first quant fund to have been launched in India. There have been a few launches in the past. But, before we come to whether you should invest in the NFO, let's understand what are quant funds, how they work and whether it makes sense to invest in a quant fund at all:

What are quant funds?

Quant funds use advanced mathematical models to select stocks based on parameters such as fundamentals, valuations, price trends etc, but these are not limited to just these. Globally, it is also called multi-factor (smart beta) investing strategy where various factors, which result into outperformance and reduce downward risks are identified and a mathematical model is built based on these. The propagators of quant funds say the scope of human error here is quite less as there is almost negligible human intervention, and hence they are likely to perform better than active funds.

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"The premise of removing human intervention from the investment process is to eliminate various behavioural biases such as herd mentality, loss aversion, recency bias, anchoring and confirmation bias and overconfidence, which may lead to poor decision-making," says Devang Kakkad, Head Investment Advisory, Equirus Wealth management.

"There are many studies on how behavioural biases tend to result in sub-optimal decision-making. It is impossible to be unbiased in our decision-making. However, we can mitigate those biases by identifying and creating rules. Rules effectively act as a mechanism to have better rationality, predictability and control in the way portfolios are managed and avoid errors," says Aparna Karnik, SVP, DSP Investment Managers.

Quant funds basically lie somewhere in the middle of index and active funds.

Index funds replicate the index constituents and the performance by minimising the tracking error while in quant funds, stock selection is done just like an active fund but nothing is left to the discretion of the fund manager.

Strategy is key to performance

How a fund is going to perform will depend on the strategy the fund is following. That can be judged only after the fund has built a reasonable track record under different market conditions.

The DSP Quant Fund will eliminate stocks, which are overleveraged and volatile. There is misalignment of management incentives as well. The selection of stocks will be done based on various quality, growth and valuations factors derived from EPS growth, return of equity and earnings growth variability and PE, PB numbers etc. There will be stock and sector-specific cap of 10 per cent. The rebalancing of the portfolio will be done in next six months.

Reliance Quant Fund model selects stock on the basis of value, growth and momentum indicators.  "The model  identifies around 30 stocks from BSE-200 index where growth and fundamentals are improving, valuations are acceptable and momentum is favourable. We have assigned highest weight (approximately 50 per cent) to quality/fundamentals factors, followed by high quality momentum factors along with two value factors to make it a diversified style driven strategy," says Ashutosh Bhargava, fund manager, Reliance Mutual Fund.

But how successful the model will be or has been can be evaluated only after seeing the performance of the fund across market cycles.

Choices are few

A few fund houses did launch quant funds in the past, but most of them have either changed their mandate or have gotten merged into other schemes. Therefore, there is not much of a history as far as performance is concerned. Currently, there is only one quant fund -Reliance Quant - which was launched in April 2008. It has an asset under management (AUM) of Rs 27 crore as per Valueresearchonline.com.

The fund has underperformed its benchmark over three and five-year period. Over five-year period, the annualised return of the fund stood at 10.34 per cent against 14.35 per cent in the benchmark S&P BSE 200, as per their website. It is also lagging its benchmark over three-year period with return of 12.59 per cent as against 14.35 per cent in the benchmark. During the market crash of 2008, the fund lost 77 per cent against the fall of 56 per cent in the benchmark. In the subsequent rally of 2009, it delivered 77 per cent against 91 per cent jump in the benchmark.

The fund has changed its investment strategy in 2018 so it may not be relevant to look at its historic performance.

Historic bias

Quant funds work on various assumptions and do a back-testing on historical data. Hence, it may not be able to account for unexpected events. "Since Quant funds are managed on a rule-based approach, they may not incorporate or may be slow in incorporating elements like market sentiment, news flows and nuanced manager views on certain industries/businesses," says Kaustubh Belapurkar, Director Manager Research, Morningstar Investment Adviser India.

For example, the market crash of 2008 and the quick recovery in 2009 were slightly unexpected events and quant funds globally struggled during these times. 2018 was also a bad year for quant fund globally.

"Markets are a complex system. Hence, it becomes extremely difficult to factor in all variables. Therefore, quant models may not be very effective over short-term horizons, where events usually define market trends," says Jason.

Experts believe that quantitative strategies are likely to perform better in efficient markets while in India a more balanced approach is expected to deliver better results.

"India is still a stock-picker's market and sensitive to many factors, which may not be captured in a quant. A balanced approach where you mix quant process with people's intelligence shall have better results. In Edelweiss Large-cap Fund, we've been following a quant process for filtering out poor quality stocks and then fund manager's inputs are used to arrive at the final portfolio. We have seen fair amount of success while following this approach over last nine years," says Radhika Gupta, CEO,  Edelweiss AMC.

Should you go for quant fund?

As far as the NFO of DSP Quant fund is concerned, we at Money Today wouldn't advise investing in NFOs, simply because they don't have a track record.

Globally, quant funds are quite popular and have built up a decent track record while in India, such quantitative strategies are at a nascent stage.

However, experts still believe that quant funds can be used to diversify the portfolio in terms of strategy. "Quant funds need to be treated as an investment style, similar to how you have value funds or contra funds etc. Investors can invest in quant funds to diversify their risk," believes Jason.

But, like any other theme, the exposure should be limited and actively managed funds should be the core of any portfolio.

"Investors should evaluate quant funds in terms of diversification. Long-term investors should prefer actively managed funds quant funds," says Devang Kakkad, Head Investment Advisory, Equirus Wealth management.

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