Fund houses bet big on mathematics to deliver

Indian MFs roll out quantitative funds using complex mathematical models.

Quantitative funds, which use complex mathematical models to buy stocks, are fast catching up in India, with Reliance Mutual Fund becoming the third fund house to go the quant way.

Reliance Mutual Fund has merged its Sensex/Nifty Index Fund and converted it into a quant fund called Reliance Quant Plus Fund that will invest at least 90 per cent of the stocks in an actively managed portfolio of 11 to 15 stocks from the S&P CNX Nifty index.

Typically, a quant fund's investments are done on the basis of a mathematical model, which will spot subtle patterns in stock price movements to help fund managers select or reject a stock.

Reliance Mutual Fund has developed its own model, in accordance with which it will pick stocks.

"We have our in-house model, which looks at various factors like valuation, earnings sentiments, price, momentum and shareholder's value. Also, we would prefer to keep our portfolio's sector weightage in line with the Nifty's sector weight (in exceptional case, 20 per cent higher or lower)," said Vikrant Gugnani, chief executive officer, Reliance Capital Asset Management.

"The investments in the portfolio will not necessary be equally weighted. The fund will be more of an active fund management approach than passive fund management and the rebalance will happen every week," he added.

Last year, Lotus India Mutual Fund had launched the Alpha Generated from Industry Leaders (AGILE) Fund that picks 11 stocks according to a proprietary mathematical model, where 9 per cent of the total corpus is invested in each stock and the remaining 1 per cent in debt and money market instruments.

Since its launch in November 2007, the fund has given a negative return of 29.9 per cent and year to date, it has given a negative return of 32.01 per cent against the average equity fund's negative return of 31.88 per cent, according to Value Research, a fund-tracking company.

"The quant strategy will typically work if investors have a timeframe of at least one year," said Rajiv Shastri, head of business development and strategic initiatives, Lotus India Mutual Fund. The fund house has recently also come out with a tax-planning version of the same fund.

"The model works best in stocks, where the liquidity is high. We are closely tracking the mid- and small-cap stocks universe to introduce more such products, but it will have to wait for some time since liquidity conditions in the market are not very good at present," he added.

More recently, Benchmark Mutual Fund also filed an offer document with the Securities and Exchange Board of India (Sebi) for the Benchmark India Value and Momentum Quant Fund that will invest in securities based on a quantitative stock selection model provided by Citigroup First Investment Management.

The model, which is a Citigroup proprietary quantitative model, seeks to identify undervalued equity securities, which also display strong price and earnings momentum.

The model uses a statistical valuation process that considers how stocks of a similar size and with similar growth and cost-of-capital characteristics, are valued in the market. At the same time, the model assesses stock momentum by evaluating both price and earnings data.

All stocks under consideration by the model are given a value and a momentum "score" "" the higher the value or momentum of a stock, the better its score in each respective category. The stocks that score the best on value and momentum scales of the model are eligible for inclusion in the portfolio delivered to the investment manager.

Quantitative models do not take into account negative news flow, but they react to market action after the negative news flow. This has also resulted in the undoing for many quant funds in the US. In 1998, Long Term Capital Management (LTCM), a quant-based hedge fund, lost over $4.6 billion as its computer models failed to provide for the possibility of the Russian government defaulting on its government bonds.

The high-frequency traders that are considered pure quants, such as DE Shaw, Renaissance Technologies and AQR, are estimated to number only about 20 worldwide, though other fund houses do have some funds using these models.

However, many of these funds, including Jim Simons' Renaissance Institutional Equities Fund launched in 2005 and designed to hold up to $100 billion, lost 1 per cent of its value, according to investors, said a report in Financial Times.

"Most quant funds globally have moved from being normal investment vehicles to leveraged investment vehicles, which help in generating higher returns. Consequently, their performance has suffered in recent times," said Shastri.

Quantitative techniques emerged in the early 1970s and gave birth to the index fund in 1971, when Wells Fargo introduced a mutual fund that tracked 1,500 stocks on the New York Stock Exchange.

As computer-processing power grew and more physicists and mathematicians left the academia for Wall Street, money managers offered more robust services and institutional investors began to embrace quantitative management for the advantages it offered.