Quant Strategies – Does it make Investment Sense?

Quantitative strategies are the latest investment craze being sold to investors - quant mutual funds, quant based ETFs, and quant portfolio management services (PMS) are being launched every month.  In fact, chances are that you have been sold a quant product by your bank or broker, and may not even realize it.  So what is a quant strategy and does it make investment sense for you?

A quant strategy is anything that uses a rule based approach to invest.  The rule could be sort all the stocks in the NIFTY by P/E ratios and invest in the ten with the lowest P/E ratios (the most undervalued stocks).  Or it could be sort all the stocks in the NIFTY by past 6 month return and invest in the ten with the highest six month return (momentum stocks).  Strategies are typically divided into two classes - strategies that invest based on momentum and strategies that invest based on fundamental factors like P/E, enterprise value, and dividend yield (often sold as fundamental index strategies).  Regardless of whether it is called a momentum strategy or a fundamental index, any rule based strategy is quant.  The benefits of a quant strategy are the objectivity, discipline and lack of fund manager bias in the process.

Quant strategies have a global track record of success and are a valuable addition to your portfolio, but are a very nascent market in India.  As a result, a lot of the standards for backtesting and returns reporting are relatively green and potentially misleading to investors.  What should you look out for when you compare quant products?

Realistic Returns - Quant strategies are not magic software that can deliver astronomical returns that no other fund manager in India can.  In fact, a quant strategy CANNOT deliver more than the best mutual fund manager in India.  Why?  Because the best mutual fund manager has a track record that is  in India and is a result of tremendous skill, luck, survivorship bias, insider information, non-quantifiable subjective analysis and much more, and that's pretty hard to beat.  Depending on the period analyzed, top fund managers in India have outperformed the NIFTY by 7-8% over a 10-15 year period.  If a quant manager is claiming that they can beat the market by much more than that, something is fishy.

Backtesting Beast - Backtesting is the bread and butter of quant, but backtesting can be very dangerous and misleading.  Backtesting, simply, is a way of repeating a rule based strategy to see how it would have performed historically.  Quant players use back tests to show hypothetical historical returns of new strategies, to give the investor a sense of how they would have performed.  It's very important to remember however that backtests are NOT a replacement for live performance.  The live performance of a mutual fund is the performance of real client money with trading costs, in-flows, out-flows, implementation issues, fees and no benefit of hindsight.  Backtested performance on the other hand has the benefit of perfect hindsight and there are many potential errors that can be made in backtests.  For instance, backtests often underestimate the historical cost of trading and assume that the manager has data that they could not have had (e.g. assuming annual results are available on 31-Mar when in reality they come out with a 6 or 9 month lag).  Backtests are subject to data mining - the ability to make the returns look as good as you want by tweaking the parameters enough.  The point, beware of backtests

Live Performance - Quant players often report "live" performance but what live means should be carefully checked.  For a mutual fund or ETF, live performance as based on a published NAV from AMFI is undisputable.  For a PMS, performance can be reported in two ways.  One is to report performance based on a traded client portfolio net of all fees and trading costs - this is accurate performance and a manager should be able to provide audited statements of his oldest client.  The second is to report model portfolio performance or simulated performance.  This is performance that doesn't account for churn, fees, trading costs, and may be very different from actual realized performance.  Moreover, once you have invested in a product, particularly PMS, track the performance of your portfolio by looking at the value of your individual account, not the return on a generic portfolio statement.

Number of Stocks - Quant as a style results in a different portfolio from traditional investing.  Because quant managers rely on data rather than thorough due diligence and meetings with management, they tend to take smaller bets across a larger number of stocks, hoping a majority will go their way.  Globally quant portfolios trade 50, 100, and even 1000 stocks, and even in a market like India, a sensible quant product should have 40+ stocks.  Quant portfolios with 10-20 stocks can be a little dangerous - quants don't do the kind of research fundamental managers do, and shouldn't hold as concentrated positions.

Manager Experience - Quant sounds academic, but investing is about real life experience trading a particular style.  It is one thing to come up with a few rules and backtest them and another thing to manage money in a live setting.  Whatever quant manager you choose should have experience managing quant strategies for live clients.

Quant, for all the above dangers, is a great investment style - globally tested, consistent and disciplined, and one that should grow in India, and I say this with full disclosure as a quant manager.  It does not need to beat every other investing style to qualify as valuable - if it can deliver comparable returns to fundamental investing in a consistent and repeatable way, it adds value to your portfolio.  What's important though is that a manager's style be run with rigor, honesty and transparency; so that investors invest with realistic expectations and realize the returns they are promised.  As with any investment product, quant sold as a marketing plug will have a short life span; quant sold to make money for investors will live longer.

Quant products available in the Indian market include Reliance Quant Fund (mutual fund) and Motilal's MOST 50 (ETF) which start at investment sizes of Rs. 500-1000+.  In PMS, products include Forefront Capital's India Opportunities and ING Large Cap Quant PMS which start at investment sizes of Rs. 10-25 lakh+.  Mutual fund and ETF investments can be made as per standard mutual fund investment norms and PMS investments can be made by contacting the manager directly.

- Radhika Gupta

The author is a Director and Co-Founder of Forefront Capital Management, a SEBI registered quant PMS manager.  She can be contacted on radhika.gupta@forefrontcap.com

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