The Mutual Fund Show: The Pros And Cons Of Choosing A Quant Fund

Is it safe to choose a quant fund? Here are the pros and cons...

A person types code on a laptop. (Photographer: SeongJoon Cho/Bloomberg)
A person types code on a laptop. (Photographer: SeongJoon Cho/Bloomberg)

Mutual fund investors can either choose a passive fund that follows an index or pay higher fee for an actively managed scheme. There is one more option—a quant fund. It’s a hybrid of active and passive investing as such funds make investments based on algorithms/ set rules with minimal human intervention.

Understanding the process behind the rule-based investing and mapping the track record would be a right approach for selecting quant funds, also called smart-beta or multi-factor funds, said Kalpen Parekh, president of DSP Investment Managers Pvt., which has a quant fund. On BloombergQuint’s Mutual Fund Show, Parekh said investing in quant funds could be like buying bitcoins, which did well in the last 10 years but if investors didn’t understand the product, it would have been like taking a speculative bet.

Aparna Karnik, senior vice president and head, risk and quantitative analysis, DSP Investment Managers, said while quant funds may not eliminate the need of human interference, this discretion is definitely minimised. Once rules are set, she said, these funds update on their own.

DSP Quant Fund weathered the volatility and beat the benchmark in the last three months.

Still, Avinash Luthria, founder of Fiduciaries, advises caution. Rules-based investing may not be enough to beat the benchmark and there would be some element of risk involved to generate extra alpha, he said. Investors pay five to 10 times higher fee compared with a passive fund the hope of getting more, he said.

Quoting Nobel-winning economist Eugene Fama, whose work led to creation of passive index funds, Luthria said, “You hope to get any extra return from smart beta factor investing because you're taking some extra risk. For example, small caps which will get destroyed or hammered in a crash. That’s essentially the crux of smart beta of factor investing.”

Watch the full video here:

Here are the edited excerpts from the interview:

Kalpen, as I learned from the conversation that we just did five minutes back, in the strictest of sense, it’s probably not even a true blue quant fund of sorts.

Parekh: So, the whole concept of quant fund starts with a very fundamental reality that there are multiple routes to heaven in the world of investing. There are different styles that create good investing results. If let’s say none of us existed, as investors you could go and buy Nifty and get the return of Nifty or any basic benchmark which represents the economy of the country. Now, to do better than Nifty is why over the last 20 years, this whole range of active funds in India have been around for more than two decades, and they’ve created enough value and wealth and excess returns over the basic Nifty. So you start with Nifty as a passive product and then you have all the active funds which are through multiple slices- we can slice and dice them as large-cap, mid-cap, small-cap, growth, value, all of that - that’s the entire range of active.

When we thought about our quant fund, and actually Aparna and another colleague Pratik, they are the architects of this fund, I’m only the messenger on their behalf - our whole thought was that there are certain traits or characteristics of fund managers within DSP, or even otherwise who demonstrate a certain style of investing which creates excess return over the benchmark. They are able to generate better returns than the benchmark over long periods of time. So we studied for those styles and then we said let’s code these styles using a quant framework and design a fund keeping the art part of it, the art is the understanding of the style, and the factors that really create excess returns over the benchmark coded in a very transparent manner which we can upfront communicate to you and to your viewers and to our investors and advisors, and then strictly follow those rules. So, it’s a combination of art and science. The art that the investing principles of good fund managers truly comes together and that art is coded into rules which you showed couple of seconds back on the slide. So, there are basically three steps. First, you eliminate companies which have rules or characteristics which never created value. So companies which have high leverage, high volatility in the stock price overtime, inefficient capital allocation, poor quality of earnings, accounting, frauds--just minimise those companies from our basic index. And then the next step is select companies on the basis of good rules, the rules of high quality businesses, rules of good valuation and the rules of good future growth. The third step then is to assign weights to these companies. So we said we’ll just blend that combination of art and science and put it together in a rule-based format.

The DSP quant fund is nothing but a rules-based fund. It eliminates weak companies, and selects good companies and stays patient and then allows you to run over a long period of time.

Today we are here at the end of one year. Our whole idea here is to replicate good investing principles in a rule based-format, and because it’s not passive, because it’s not completely active, you mentioned about fees, the fee structure is somewhere in between. The fees are half of what active funds would charge but of course, they are slightly more than what completely passive funds would charge because this is not a passive fund completely. This is not an active fund either. It’s a combination of the two. So globally, they call it smart beta fund or multi-factor fund, and that’s what the DSP quant fund is all about.

Aparna, you want to add to that? Do you envisage that products in such a category could actually mushroom or grow in size and in number because of the experience that let’s say, you’ve had? Are there other peers who are doing this? Or are you as a house looking to do more of such products as well with whatever little success you had in one year? I must say one year is too short a time frame anyway.

Karnik: We now have more than 30-40 years of data globally on these type of quantitative techniques to investing have mushroomed with the incremental computing power which is available and the evolution of finance as a field in academics as well. So, like Kalpen said there are factor funds globally. This is one of the fastest growing categories globally with more than 3 trillion of AUM managed on smart-beta funds across different segments like hedge funds, mutual funds, prop desk. So, it’s not something very new, it’s something which is already happened globally. So, it is something which has a similar experience in India as well. The reasons for this is just, again, as information becomes more easily available and computing power increases, those things or those investment principles, which many investment managers globally, many active managers apply like somebody has a value oriented style, so then that can be converted into rules. That that can be converted to mean companies which maybe have a price to book which is cheaper or companies for instance, which have a higher dividend yield or when they say quality companies you can code that into companies which have more stable earnings or better ROEs. So, these investing principles, which are universal, which can be converted into measures and therefore applied to portfolio construction in a very seamless way with the new tools and with the kind of computing power we have. It is something which investors like because they’re able to get that additional excess return of that style at a very low cost in a very transparent manner. And that’s where factor funds are really done very well, globally. So I do believe that these funds are going to grow exponentially in India. Even if somebody doesn’t label it as a quant fund, but the application of quantitative techniques on investment management is something which is going to grow exponentially. It’s going to grow exponentially in India.

Aparna, how much of human intervention versus the quant application would be there in this fund? And is there a possibility that the human thought process to changing the components can overwrite the larger proportion of the quantitative testing or choosing?

Karnik: No, absolutely not. Once the model is created, the model is running the portfolio on a day-to-day basis. So I think where the human element comes into the picture, and this doesn’t take away from the fact that it’s a fund which is quant. Quant is nothing but quantitative and the fund is run purely on a quantitative manner. There is no human discretion, but where the human element does come in is- we do a lot of research. The design of the model or the design of the rules, there is a lot of research and that’s where our team comes into the picture. So, we do a lot of research on globally which factors are working, why are they working? What are the behavioural reasons? Or the reasons why they deserve that risk premia? What are the measures to code for these factors? So, we evaluate these on an on-going basis and then we keep on testing whether they have a potential to generate alpha in a very consistent and robust manner. And if we feel for instance that yes this rule or this factor or this principle has the ability to generate meaningful alpha and it is tying in very well with fundamental principles, then we will go to our investment committee to apply it into the model, but once the model is running, then there is no human overwrite on that.

Quant is a very generic term. It includes all kinds of funds — factor funds on which DSP quant fund is largely built on, macro-based funds, algo-trading funds. Quant is short for quantitative. Our fund is a rules-based multi-factor fund, which is coded based on fundamental principles.

Kalpen, you want to add something? Do you reckon that such funds for either lower expense factor or less human intervention factor or a combination of both could actually find greater acceptance?

Parekh: My take on this is why would I invest in this fund or why would you invest in this fund? To start with, the starting point should be that do you believe in the principles of the fund rather than the expenses alone or rather than just the fact that there is no human intervention, because then we are making an assumption that wherever there is human intervention, that’s bad. But that’s not the case.

What we are saying is, first of all, understand what are the rules. So whoever we talk to we say that don’t look at our performance first, don’t invest because you like the word quant, understand what are the rules. If you’re a believer that these are the rules, which can create better returns than the alternative benchmark, if you believe in these rules, then you should invest in this fund. Number two, once you believe in the rules, then look back that has the portfolio effectively reflected these rules and how good is our execution. So for example, our model has been tested for almost 16 years now. And it is now live for the last one year. So one year back when we