Kotak Quant Fund NFO: Only for select investors

How do you stand a chance to earn more returns with as little volatility as possible? Kotak Quant Fund (KQF), the new scheme by Kotak Mahindra Asset Management Co Ltd (India’s fifth largest fund house with assets over Rs 2.97 lakh crore), aims to do something like that. KQF, its first quantitative fund, launches on July 12.

What does the fund do?
At the heart of it, KQF by Kotak Mahindra Mutual Fund is a thematic equity fund. Using the combined expertise of human fund managers as well as computer programs, it aims to pick stocks that it thinks would do well in rising markets as well as protect the downside in volatile markets.

From its starting point of 800-1,000 stocks, KQF will narrow down the basket —through human intervention — to close to 150-200 stocks by weeding out stocks based on low liquidity, weak financials and bad governance. From here on, the fund house’s algorithm will pick around 35-50 stocks from this shortlisted universe, based on momentum and volatility factors. In simple words, stocks that demonstrate high growth and low volatility.

What works?
Quant funds have a more rigorous approach to stock picking than smart-beta passive funds. Like a typical quant fund, KQF will shortlist the universe of stocks it would invest in. This border will be drawn manually. The algorithms will finally choose and pick stocks that the fund will buy. To this extent, the fund has an active screening process.

Also read: Want to know the best mutual funds to invest in? Check out the MC30 basket

This, explains Harsha Upadhyaya, Chief Investment - Equity and Debt, Kotak Mahindra AMC, means that the botheration to replicate the portfolio is done away with. Upadhyaya says that in traditional smart-beta passive funds, many benchmark indices have mid-cap stocks and even some small-cap stocks. “When such stocks hit their circuit filters — either on their way or down — they become illiquid. And as a result, fund managers either cannot buy or sell such stocks or cannot transact at a price. This results in a wide tracking error,” he says. KQF, due to its active fund management, can filter out such stocks at the liquidity stage.

KQF can get even more active if there is a high impact cost (difference between the trade price and market price) for a particular stock, if there are high inflows or outflows or if there is a corporate action, say a merger.

KQF is the fund house’s first foray into quant funds. But its track record in equity funds has been good. Three of its equity funds are a part of MC30 — Moneycontrol’s curated basket of 30 investment-worthy mutual fund schemes. To bolster its quant team, Kotak AMC has hired two data scientists whose responsibility is to build models, based on the fund management teams’ inputs, that help pick stocks. Based on KQF’s track record, the fund house might increase this team.

The fund house has back tested the model since 2005. In 14 of those years, it has outperformed its benchmark index, Nifty 200 TRI (Total Returns Index); mostly by 6-25 percentage points.

What doesn’t?
The drawback of quant funds is that they look more towards the past and less towards the future. “The selection bias based on only a few rules is not good for the fund's investors as the model has limited data with only a few factors captured. We saw in the last three years how the markets went down and rebounded back. The shift from growth to value and now gradually moving to a blended style…I doubt if quant funds capture this in advance. It’s only in hindsight that the model gets adjusted to the on-going realities and changes the portfolio accordingly,” says Ravi Kumar T V, Director, Gaining Ground Investment Services. Upadhyaya of Kotak Mutual Fund says the fund house has back-tested for the past 18 years. Ravi Kumar says 3-4 decades testing is required, "to capture market cycles data, macro volatility along with investor sentiment."

That apart, quant funds by themselves do not have a long track record in India to give confidence of how they have performed across market cycles. Of the roughly seven quant funds in the Indian mutual funds industry, only one has a track record of more than three years. In the last two odd years, single-factor funds, popularly known as smart-beta funds, have become more popular.

To be sure, there is no official industry differentiation between smart-beta funds and quant funds. The one thing that often differentiates between the two is that while typically smart-beta funds are passively-managed, quant funds are actively-managed. “Quant funds have a significant fund manager intervention. In the case of KQF, the fund managers’ intervention is at the start where they filter out stocks based on quality and governance. After this stage, the machine takes over different quant funds and then follows different methodologies,” explains Srikanth Bhagavat, managing director, Hexagon Capital Advisors, which runs Hexagon Wealth. But more such passive smart-beta have been launched by the industry in the past couple of years, as compared to quant funds. KQF aims to break this trend.

But coming back to performance, quant funds have underperformed large-cap, large-and-mid-cap funds and flexi-cap funds over the past three-year period. But in the past year, many quant funds have done better than category averages of more-diversified equity funds. Bhagavat advises smart-beta funds to some of his clients. “Quant funds and smart-beta index funds are worth trying but very selectively. They are not needed for all portfolios. But high networth individuals who are already well-diversified can invest in them selectively. Those who have knowledge of how factors work and have used smart beta in the past can invest in quant funds,” says Bhagavat.

Vinod Jain, principal advisor, Jain Investments Planner Pvt Ltd says that he prefers to stay from quant funds, for now, due to a lack of history. This, he adds, doesn’t give him enough confidence as of now. “But I will keep my eyes open to it all the time,” he adds.

Moneycontrol's takeKQF is an ambitious target by a fund house with a good equity fund management team that has a proven track record elsewhere. Its experienced fund management team gives us some confidence that a lot of thought has gone behind the scheme’s structure, especially its path to eliminate companies based on performance, in order to come to an investible universe of stocks in which the fund would invest. This is done with an aim to prevent accidents and unnecessary volatility. Ultimately, how well the fund does in future will depend on how the algorithm picks stock winners.

KQF is not meant for beginners. It’s only meant for those who have a sizeable portfolio already and understand the risks that come with factor investing and are okay with lack of a track record of not just a new scheme.

The NFO ends on July 26.