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Do you need to add quant funds to your portfolio?

Quant funds follow rules-based investment pattern; while the setting of rules is an active process, the stock selection based on these rules is passive with no human bias.

The debate usually is whether to pick an actively managed or a passive fund. With the option of quant funds this debate now picks up another dimension. Quant funds follow rules-based investment pattern; while the setting of rules is an active process, the stock selection based on these rules is passive with no human bias.

The case for rules-based equity portfolios

A typical active equity fund requires a fund manager assisted by a team of analysts to pick individual stocks for the portfolio. This portfolio is what you invest in via an equity mutual fund. The fund is benchmarked to an index which is actually a passive portfolio of stocks built on the basis of quantitative factors. The aim of the fund is to use the fund manager’s and analyst’s expertise to deliver returns consistently above benchmark returns.

In the current market cycle, there has been criticism that large cap equity funds have failed to deliver out performance against the benchmark such as the Nifty or the Sensex in a 1-3-year period. This has built a case for simple passive strategies which are able to deliver returns almost mirroring the benchmark at a much lower cost.

Here is what you need to understand. The quant-based strategy will only be as good as the rules that it follows. Whether the rules work across market cycles or not will be known only after the fund has had few years of real time performance.

At the same time, the historical outperformance experience from active fund managers has been good, thus, keeping the case for active strategies alive. Quant based funds which lie somewhere between active and passive strategies, seem to be the next step in this changing scenario.

The rules-based approach in quant funds, is to eliminate unwanted stocks and then select those which can be included from a pre-determined universe of stocks defined by an index. However, once defined, the fund manager cannot alter the rules to pick stocks, especially those that they may be emotional about or feel intuitively about.

A quant strategy will also define how much of an individual stock can be included in the portfolio. Once again, this process is formula based with no involvement from the fund manager once the formula is set.

Is it for you?

Here is what you need to understand. The quant-based strategy will only be as good as the rules that it follows. Whether the rules work across market cycles or not will be known only after the fund has had few years of real time performance. Secondly, while the rigid rules can protect you from the risk of fund managers’ emotional take on stock selection, it can work against your return expectations in developing, and still inefficient, markets like ours.

The fact that different market players have different levels of access to information and sentiment driven prices in the short term can present opportunities that reward good quality fund managers. Following rules does not imply out-performance against benchmark; if the rules don’t work, the fund will underperform.

Don’t rush into quant strategies too soon, wait for performance results in long periods of 3-5 years before making the choice. Plus, if the active funds you own are able to deliver your expected returns, there is no need to go looking for a quant fund.

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