Computer-based system shines as active fund managers underperform

Mumbai: It was perhaps the first litmus test for ING Investment Management’s quant fund. With approaching election results, the market was gyrating wildly and many mutual fund houses were holding anywhere between 25-40% cash in April 2009. However, against prevailing wisdom, ING’s recently launched large-cap focused PMS quant fund stayed invested (98%) in the market.

The strategy paid off. On May 8, the Sensex rose 2,000 points when it became certain that the Congress-led UPA would sweep the polls. While most fund houses lost out, ING’s quant portfolio took a quantum leap.

Instances such as this have encourage some Indian players to experiment with a new style of managing money—through automated, computer-modelled ‘quants’ instead of flesh-and-blood fund managers. The abysmal track record of active fund managers has also prompted high net worth individuals (HNIs) to give these passive, mechanical models a try. According to recent report by S&P Crisil Spiva, almost two-thirds of equity-oriented funds across both large-cap and equity-linked savings schemes have underperformed the benchmark index over a 5-year period.

“After the global financial crisis, HNIs are more willing to try out process-driven approaches. There is a focus on the investment process rather than on short-terms returns or a few great stock picks,” says Radhika Gupta, director and one of the founding members of Forefront Capital Management, a boutique quant firm.

To be sure, quants have been around for more than two decades globally. In India, though, it’s largely a two-year-old phenomenon. ING Investment Management, Forefront Capital Management and Benchmark Mutual Fund currently offer quant products through the portfolio management services route. Reliance Quant Plus Fund, Motilal Oswal’s M50 Exchange Traded Fund and Religare Agile Fund are among the existing quant funds in the mutual fund space. Pramerica Asset Managers and IDFC MF are believed to be launching quant funds soon.

“Quants are relatively new to India where 99.9% of investors, including HNIs, are invested into traditional products,” says Navin Suri, chief executive of ING Investment Management, which has three quant products under its portfolio, with assets under management (AUM) of about Rs 1,000 crore. “In the US, about 20% of the investment corpus is in quants.”

Quants are modelled on mathematical and statistical parameters based on a company’s historical data such as earnings, profits, valuations and macro-economic data such as interest rate movements. It can take anywhere between six months and 2 years to built a particular model and a few more months for back-testing it. These funds are targeted at HNIs and super-HNIs. Typically, the minimum investment required is Rs 10 lakh with fixed charges akin to mutual fund expense ratios ranging between 1.5-2.5% p.a. There is no lock-in period.

Diversification and risk management are the two primary benefits of a quant fund. One of the popular strategies is multi-asset allocation where the corpus is invested across asset classes such as equity, gold, cash and fixed income. “Today, investors are anxious as the market is dancing to global tunes. Quants can help manage risks arising out of volatility,” says Vijai Mantri, MD & CEO, Pramerica Asset Managers. According to Suri, unlike human analysts, quants can analyse a wider breadth of companies equally well — and without behavioural bias.

Interestingly, the global demand for quants took a nosedive in the aftermath of the Lehman collapse in 2008 as investors yanked billions of dollars from several products. According to a recent New York Times article, the combined assets of quantitative funds specializing in US stocks have plunged to $467 billion, from $1.2 trillion in 2007, a decline of 61%. The assets of quant hedge funds have dwindled by about $50 billion and one in four quant hedge funds has closed since 2007.

The performance of these funds took a beating as time-tested relationships between asset classes fell apart and mathematical programmes which relied on historical data came to naught. In fact, most of these funds are believed to have gone short on the same scrips during the crisis, triggering a cascading collapse in their prices. What’s worse, some of the quant hedge funds were highly leveraged.

Their fall from grace, however, hasn’t dampened the enthusiasm of Indian fund managers, who are quick to defend these models. “Quant strategies are not the only strategies that suffer from the Black Swan risk,” insists Gupta. According to her, it’s the high leverage strategies and not quants per se that have backfired. “No one strategy can perform all the time. Quants work well as a supplement to the more traditional methods of investing,” admits Suri. Indian quant managers have also learnt from the mistakes of their global counterparts. One lesson is that it is important to tweak models to suit newer macroeconomic realities rather than religiously follow a rigid pattern.

Thankfully, by some measure, quants haven’t done too badly in India so far. For instance, as on August 2010, ING’s Adapt portfolio has given 1-year returns between 9.18% (very conservative) and 23.07% (very aggressive) against Nifty’s 15.8%. As on July 2010, Reliance Quant Plus Fund has given a 1-year return of 18.6%, while Forefront’s flagship product India Opportunities claims to have outperformed Nifty by nearly 7% in its live portfolio over one year.

Yet, it’s difficult to judge their absolute performance. For one thing, returns vary significantly depending on the risk profile of the investor. For another, many funds claim that returns can also vary significantly depending on the exit and entry strategy of individual investors as there is no lock-in period. “Most of these funds are less than three years old. So, it is too early to meaningfully assess their performance,” says Dhirendra Kumar, CEO at Delhi-based MF tracker Value Research India.

“Expectations from quant funds are too high in India,” reveals Gupta. “Just because it is a new investment style doesn’t mean it’s going to work magic. If you look at global numbers, the best a quant fund can do is give returns in line with the best performing mutual fund. But that doesn’t make it a bad investment.”

Talent may be an issue as well. Currently, “only a handful of the brightest IITians are picked up and trained from India by global quant firms,” reveals Sandeep Juneja, an associate professor at Tata Institute of Fundamental Research, who has headed Bank of America’s quantitative operations in India for about a year. Globally, quant models are prepared by top-notch economists, mathematicians, physicists and computer science PhDs.

Understandably, investors are reluctant to repose their faith in these complex, and often abstract, mathematical models. Total AUM are still pegged at about Rs 1,500 crore. Internationally, Goldman Sachs Asset Management and AQR Capital Management together manage around $70 billion. What’s more, there is still no institutional market for quants in India. That itself hints at both the disparity and potential for quants here.

Quants players are well aware of this and are doing all they can to woo investors — through client seminars, education programmes, one-on-one meetings and advisory services of their distributors, mostly banks. “The future for quants is very big in India. Besides, quant is a scalable business model and billions of dollars are managed by investment teams of 10-20 people globally in quant strategies,” says Gupta. Suri is optimistic quant products will comprise 8-10% of HNI portfolio in the next 5 years. Many players, in fact, are already planning to introduce new quant products.

It won’t be smooth sailing, though. Structural issues such as low liquidity in Indian markets may, in some ways, mar the performance of quants. “Many a times, trading volumes in the market is not driven by fundamentals. Also, volumes drop significantly as you go below the top 60 to 70 stocks,” says Sanjiv Shah, executive director, Benchmark Mutual Fund, which currently offers three quant products. And since many of the quant strategies like mean reversion work on the principle of reducing risk (buy at dips and sell at highs), it might be difficult for investors to maximize returns.

“Quant funds tend to underperform in an uninterrupted bull market,” confesses Mantri. But, as professor Juneja points out, “the demand for quants will rise as Indian markets mature and more foreign banks set up shop here.”