Quant mutual funds: Decoding the math behind algorithm-driven schemes

The money management space, like other spheres of business, is increasingly turning to technology-enabled strategies such as algorithm-driven processes, quantitative analysis, artificial intelligence (AI)/machine learning (ML) tools to take key investment calls.

Quant, or quantitative funds, constitute a category of mutual fund (MF) schemes that rely heavily on these resources for stock selection, redemption, portfolio rebalancing and other crucial investment decisions. While conventional funds, too, employ these strategies, quant funds — particularly the passive ones — bank almost entirely on technology to guide the investment decisions.

There are 10 active quant funds on offer, with SBI Quant Fund’s NFO (new fund offer) set to open for subscription on December 4, making it the 11 in the list. Total assets under management (AUM) for the active quant fund category amounted to Rs 9,000 crore as of October 31.

Here’s a look at the key features, advantages and limitations of this fund category:

How do quant funds work?

Quantitative funds, as the name suggests, utilise algorithm-driven mathematical models and AI tools to formulate and execute investment strategies. They employ statistical models and quantitative analytical tools to dig deep into the enormous pile of market data available to come up with investment strategies that can deliver the desired outperformance.

Within this category, investors can choose between passive and active schemes. In the case of passive schemes, there is barely any role for the fund managers to play. Active quant funds entail the fund managers creating an algorithm-driven investment framework and deciding the screening parameters at inception. Once the rule-based framework is in place, the active fund will replicate the model portfolios.

To be sure, even regular, non-quant MFS do employ mathematical models and quant-based strategies for taking investment calls, when needed. But quant schemes rely nearly exclusively on algorithm-based mathematical models.

Also read: Multi-factor investing can help reduce drawdowns, deliver better risk-adjusted returns: Sukanya Ghosh

What are the different type of quant funds on offer?

Besides active and passive, there are variations in terms of the factor-based approaches that they follow too. Single-factor schemes could rely on momentum, valuation ratios, quality or low volatility, while multi-factor funds take into account two or more of these parameters. “Usually, multiple factors are determined and the decision-making is based on these parameters. These funds may not rely on the skills and expertise of the fund manager but on the different factors considered at the time of building the mechanism for the fund. The traditional actively managed funds are based on the fund management team’s research where they take a call on the portfolio based on their skills and views on the market conditions,” said Harshad Chetanwala, financial planner and co-founder, MyWealthGrowth.com.

What advantages do quant funds offer over conventional or regular MFs?

They eliminate the behavioural bias of the fund managers or the fund houses. Algorithm-led quantitative analysis is also likely to result in a more meticulous approach to stock picking than conventional funds. Passive quant funds come with minimal human intervention, doing away with the risk of human bias and errors.

In the case of active quant funds, the fund manager’s intervention entails shortlisting the universe of stocks they would invest in and defining a set of rules and boundaries.

Also read: Are quant and algo funds suitable for retail investors?

Are there any limitations the investors need to be aware of?

While quant funds can eliminate human behavioural biases, their outlook is narrower as they strictly adhere to a few rules set in the beginning. Having to follow model portfolios created on the basis of historical performance and patterns means that they look more towards the past and may lack the flexibility to adopt a forward-looking approach towards stock selection.

“There is always a debate around whether elimination of the human behaviour element is a more fool-proof approach or is it better to rely on the tried-and-tested, conventional method where fund manager’s skills come into play. Quant funds could be complex for lay investors to grasp. From diversification perspective, they can consider an allocation of up to 10 per cent of their portfolio,” said Kalpesh Ashar, founder, FullCircle Financial Planners and Advisors.