Quantitative funds use mathematical models to invest in stocks. Here's a look at how you can gain from them
HAVE you heard the old joke that goes like this: "How did the high school student define maths? Well, he thought it's an acronym for Mentally Agitated Teachers Harassing Students or M.A.T.H.S."
But as you would agree, despite harassing high school students, maths, over the years has been put to good use, including for making wise investment decisions. Over the past few years, the new investing field of quantitative investing has been putting mathematical models to good use to make investment decisions. These mathematical models are built using economic and financial data.
Globally, quantitative investing has been well-established for the past three decades. As much as 20% of equity money in the United States is managed using quantitative methods.
Compared to this, less than 2% of money in India is managed using this technique.
So, how is quantitative analysis different from traditional analysis and should you consider this option of investing?
The Story So Far:
Most professional investment managers currently follow what is known as the fundamental analysis style of investing. In this method, analysts meet company managements, make plant visits, evaluate financial performance and arrive at what they think is the appropriate valuation or fair price for the stock.
If the stock currently quotes below this fair value, the analyst concludes that the stock is worth buying. The stocks recommended based on fundamental analysis are typically held for 1-3 years. For making investment decisions in the short term, analysts and fund managers use technical analysis. Technical analysis is for the short term. Compared to fundamental analysts, technical analysts use past price movements and volumes traded in a stock to arrive at a future price. However, most technical analyses are short term in nature (around 3-6 months) and can even be for a time frame of as short as one day.
So What's Quantitative Investing?:
Quantitative funds offer a scientific approach to investing in stock markets based on mathematical models. Quantitative investing is any strategy that is rule based and involves no form of manager bias or subjectivity. Rules vary in complexity and can be based on any kind of data set such as financial, statistical, economic or accounting data. Quantitative models, however, work well with large-cap stocks (basically the 100 biggest stocks in the Indian market). This is because to build a good quantitative model and back-test it, you need a lot of past data, going back to as far as 10-15 years. The quality of data deteriorates as you get into the smaller companies, and this can have an impact on the quality of the modeluri.
During the time of the global crisis in March 2009, several fund managers went into cash to the extent of 20-50% of their portfolio. As there was a human bias involved, most missed out on buying good stocks which were available at attractive prices.
However quant models, benefited purely because they were fully invested as per their mathematical models.
Once the model is tested, there is little scope for human intervention, unless there are scenarios such as the collapse of a company due to exceptional circumstances such as a fraud. The quantitative analysis is undertaken using computer-based models which are designed by the respective managers. These strategies are offered by a few mutual funds and some portfolio management providers.
Where To Invest?:
The quantitative fund manager creates a quant model based on pre-determined variables such as sales, profits and sales growth. Take the example of M50, a quant-based exchange traded fund from Motilal Oswal Asset Management. It takes all the 50 stocks in the Nifty and creates a model using four parameters namely, return on equity, net worth, retained earnings and stock price. Based on the rank in the model, each stock gets a weight. Using this process it attempts to deliver superior investment performance by trying to allocate more capital to companies that are expected to deliver relatively stronger returns and less capital to companies which are expected to deliver relatively poorer returns. As of December 2010 end, the M50 basket was overweight on 18 companies, and had allocated 68% of its portfolio. Compared to this, the Nifty has allocated 22% weightage to these companies.
As far as investors are concerned, there are a few products available from mutual funds, broking firms as well as PMS providers.
You have mutual funds like Reliance Quant Plus Fund and Religare Agile Equity Fund and Religare Agile Tax Plan and Edelweiss Absolute Return Fund that use quantitative strategies.
The objective of our fund is to generate absolute returns with low volatility over a longer tenure of time. Besides this, the broking house at Edelweiss offers quantitative baskets to investors. These baskets contain a group of stocks which investors can buy and hold. "These baskets are selected on the basis of parameters such as relative price momentum, earnings performance, price-to-earnings ratio, sales growth, operating profit growth and so on, business head, Edelweiss Broking. There are separate baskets for large-cap and mid-cap stocks.
Broking house, Sharekhan, offers a product called Nifty Thrifty which uses quantitative modelling. Towards the end of the day, the model throws a signal to be either short or long on the Nifty. The idea of this product is to offer absolute returns to investors.
Quants For Your Portfolio:
Like all strategies, the quantitative model, too, has its advantages and disadvantages. However, a point to note is that quantitative investments are not absolutely safe. The biggest issue with these products is that you do not necessarily need to understand the reasoning behind stock selection or initiation of a trade. Most portfolio managers claim their models are proprietary in nature and, hence, you may not necessary know what is the exact model used by them. Here investments done based on fundamental analysis of companies have an edge over the quantitative model. Also, quantitative investors typically maintain exposure to derivative products, leaving them exposed to the risk associated with leverage. In such circumstances, risk-management techniques become important and emerge as the deciding factor between success and failure.
Instances such as the failure of the well known hedge fund Long Term Capital Management which used to employ quantitative principles, clearly underline such issues with this investment style. Hence, such styles of investing are suited for slightly sophisticated investors.
Quantitative investments outperform in secular trading markets. However, they could underperform if markets are unsure of the direction. He advises investors to allocate around 2-5% of their portfolio to quant funds. Quant works well with large-cap stocks, so investors can have about 30% of their large-cap stock allocation towards quant funds. In all, she advises investors to allocate around 10% of their portfolio to quant funds.
