Explained: How quant funds eliminate fund manager subjectivity

Just as food can be classified based on its nutrients, stocks, too, can be categorised based on their risk-return characteristics, called factors.
ICICI Prudential Mutual Fund (MF) is the latest player to enter the nascent category of quant funds. Its new fund offer will end on December 7. 

The other three existing players are: Nippon India, whose fund is the oldest; DSP, whose fund has the largest corpus (Rs 447 crore); and Tata, which was launched in January this year.  

Just as food can be classified based on its nutrients, stocks, too, can be categorised based on their risk-return characteristics, called factors. 

Some of the key ones are quality, growth, value, and momentum. By doing a back-testing, fund houses develop models that allow them to pick stocks based purely on the quantitative data. 

Most quant funds are based on a combination of factors. DSP Quant Fund, for instance, selects stocks based on three factors — quality, growth, and value.

These funds eliminate human biases. “They are model-driven, so they tend to do away with any human bias in stock and sector selection and in deciding the weight of stocks,” says Chintan Haria, head-products and strategy, ICICI Prudential MF.

Quant funds offer transparency. 

“In an active fund, a fund manager may at times take a few subjective calls. These may sometimes work and sometimes not. In quant funds, there is complete transparency on stock selection criteria,” says Anil Ghelani, head of passive investments and products, DSP Investment Managers, who manages the DSP Quant Fund that has fetched a return of 20.63 per cent over the past year. 

Since the alpha delivered by actively managed funds diminishes, these less expensive, rule-based funds are expected to find more space in investor portfolios.        

Quant funds are slightly different from multi-factor exchange-traded funds (ETFs). The latter replicate publicly available indices. If a multi-factor ETF does well for a few years, other fund houses could launch the same product. 

“In quant funds, each fund house will use its own proprietary model,” says Ghelani.     

No particular investment style works all the time. By adopting a multi-factor approach, quant funds try to tackle this challenge. 

Nonetheless, there will be years when none of the factors in a fund’s model works. Investors need to be prepared to hold on to these funds during such periods of underperformance.       

Barring Nippon India Quant Fund, these funds don’t have much of a track record. 

“Market conditions change. A model that has worked in back-testing may not necessarily work in actual market conditions,” says Vishal Dhawan, chief financial planner, PlanAhead Wealth Advisors.

The lack of fund manager intervention can at times be a weakness. 

“Even if a fund manager has strong conviction on a sector or stock, he cannot act upon it in these funds,” says Rajesh Cheruvu, chief investment officer, Validus Wealth. 

Inflexion points in the performance of sectors and companies, and emerging trends, get captured earlier by quantitative research, which active fund managers and their analysts carry out. They take longer to get reflected in numbers, which quant funds rely upon.

Some experts believe active funds still have an edge. 

“Among long-only funds, active funds will still generate alpha, though identifying the right fund managers will become increasingly crucial,” says Cheruvu.     

Early adopters, who believe a rule-based approach can create a good outcome over the long term, may invest in these funds. 

Take a small exposure and increase it as you gather confidence in the fund. Cautious investors may wait until these funds establish a longer track record.   

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