You will find software playing a significant role in decision making when it comes to investments. The financial services industry has embraced technology in a big way, and algorithmic programmes are helping mutual fund managers pick suitable securities. You have quant funds, which are essentially rule-based mutual fund schemes.
It uses customised statistical models and algorithms on vast data sets to predict the future prices of stocks and other securities. You have fund managers and the research team selecting stocks for actively managed equity mutual fund schemes. However, fund managers don’t have a significant role in quant funds as the buying and selling stocks take place through algorithms. Should you invest in quant funds?
How do quant funds work?
You have quant funds following a scientific investment process which eliminates human bias or emotions from investment decision making. For instance, mutual fund managers may be vulnerable to emotional and cognitive biases. It involves making investment decisions based on personal feelings or sticking to investment concepts that may not be accurate.
Quant funds follow rule-based investing and use predetermined filters to select the right stocks and construct a portfolio. You have the fund manager’s role limited to reviewing the model once each year or making minor changes as and when required.
You have the quant model analysing the past stock market movements or the change in the stock prices over some time. It searches for patterns in the past and extrapolates them into the future. For instance, you have factor-based strategies such as value or growth and mathematical such as technical analysis.
You have a quant fund eliminating companies that have high debt or stocks that are highly volatile. It then evaluates companies based on earnings, high dividend yields, return on equity, estimated growth of earnings in the future and other parameters. You have the stocks weighted appropriately to bring down stock and sector concentration which also reduces liquidity risk.
You have quant funds outperforming both large-cap funds and Flexi-cap funds in the calendar year 2020. For instance, the quant fund category delivered around 22% returns against 15% for large-cap funds and 17% for Flexi-cap funds. However, they underperformed as compared to mid-cap funds and small-cap funds.
Should you invest in quant funds?
You may invest in quant funds if you prefer rule-based investing, which takes emotions out of the investment decision making process. It is suitable for long term investors as many actively managed funds have failed to beat their benchmark index in recent times.
You must choose a quant fund only if you understand the investment model it follows. Moreover, you must invest in quant funds in a staggered manner to build sufficient exposure in your portfolio over some time. You may consider allocating about 10%-12% of your portfolio towards quant funds.
You may opt for passive investments such as ETFs or exchange-traded funds and index funds if you are a conservative investor. However, you could consider allocating a small portion of your portfolio towards quant funds if you want to diversify your portfolio beyond index funds and ETFs. It has a higher expense ratio than index funds but lower than most actively managed mutual funds.
What are the advantages of investing in quant funds?
- Quant funds follow a rule-based model and make faster investment decisions as compared to human beings. It eliminates human error and biases such as loss aversion and preference for specific stocks.
- Quant funds bring diversification based on investment strategy to your portfolio.
- Quant funds follow a passive investment strategy to an extent. It has a lower expense ratio than actively managed funds, where the fund managers have a significant role to play.
- Quant funds have built-in checks on stock and sector concentration compared to passive funds that track a market index.
You must study the investment model of the quant fund to select a suitable investment. It helps if you invest in quant funds for the long term to maximise your return. You have quant funds using mathematical models to time the entry and exit of stocks. However, the fund manager does play a role by designing and monitoring the model, which throws up the portfolio choices. In a nutshell, you may invest in quant funds if you prefer stock picking based on automatic programmes.
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