What are Quant Funds?
Quant funds, also known as quantitative funds, are types of investment funds in which the investment selection and related decisions are taken not with the help of human intellect and judgment but are taken by analytical methods and advanced quantitative analysis.
Inactive funds, the manager of the fund, makes decisions about the timing entry and exit of the investments, which is not so in the case of quant funds wherein numerical methods, automated programs and, quantitative models are used to make decisions about the same. But that doesn’t mean a quant fund manager would have his hands off like an index manager. Here the fund manager would still be responsible for monitoring the quantitative/ arithmetical/ analytical model that comes up with the portfolio choice.
How Does a Quant Fund Work?
Quant funds can be said to be a cross-breed of actively managed funds where a fund manager is always required to manage it and index fundsIndex FundsIndex Funds is a form of mutual fund constructed to replicate and match the performance of a particular country's index like S&P, NASDAQ, etc., and helps investors take broad market exposure due to the amount invested in various stocks of the different sectors of the economy. where a fund manager is not required because index funds are the replicas of the market.
In the investment process of such funds, there are three steps or parts. Let us know about these steps in detail:
- Input System
In this step, inputs are provided to the system. Companies with good factors such as Dividend yieldDividend YieldDividend yield ratio is the ratio of a company's current dividend to its current share price. It represents the potential return on investment for a given stock., earnings growth, return on equity On EquityReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit., free cash flow yields (FCFYFCFYThe free cash flow yield is a financial ratio that compares the free cash flow per share to the market price per share to determine how much cash flow the company has in the event of liquidation or other obligations. ), etc. are chosen without any bias, and the stocks of companies with high risk, high debts, stocks with high volatility and inefficient capital allocation are eliminated. That means long term denigrators of alpha are done away with, and durable sources of alpha are selected.
- Forecasting System
In this step, estimates and forecasts regarding the prices, risks, returns, and other factors are generated. The evaluation of stocks is done at this stage.
- Portfolio Construction
After inputs are entered, and forecasts are generated, a piece of portfolio advice is constructed. Each such stock selected is given appropriate weights so that risk is reduced to an acceptably low level, and returns generated would be as desired. That means an optimum portfolio shall be constructed in this stage.
Example of Quant Funds
Let us consider the example of the DSP Quant Fund. This fund happens to choose stocks that have high return potential and consistent earnings. Thus, while selecting stocks, the stocks of companies with high leverage and volatility would be eliminated.
The main motto of such funds is three folded:
- Buying good stocks at reasonable prices
- Holding such stocks for right periods and
- Remaining unbiased and not attaching emotion while investing.
The three-step process as stated above (input- forecasting- elimination) is followed above, and in the first step, 80-100 companies are eliminated, the stocks selected are tested for the factors such as growth, potential, returns, etc. and then weights are allocated so that there is proper diversification and also reduction of stock and sector concentration so that no stock can occupy more than 10% of the entire stock and weight of any sector shall also be around 10%, nothing much higher.
Importance of Quant Funds
Investing in Quant funds is essential because they reduce the human biases, build a portfolio by adhering to the basic rules of investing tested over the market cycles, keeping it simple with minimal human interference. The basic rules of investing are buying stocks of good companies, not overpaying for the same, and being unbiased, which are the rules exactly followed by the Quant funds managers.
- Such types of investmentsTypes Of InvestmentsStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. would eliminate human bias and prejudice.
- The expenses are lower than those of active funds because a passive and consistent strategy would be followed.
- Usage of a model permits consistency in the investment strategies across all market conditions and, as a result, the risk controlRisk ControlRisk control is the activity of analyzing, interpreting, and assessing the business environment and decisions in order to minimize losses by detecting pitfalls and preventing businesses from falling victim to calamities, hazards, and avoidable losses. would be superior.
- The occurrence of errors would be reduced drastically.
- Human emotion, fatigue, etc. would not show any effect on the investment as there would be minimal human intervention.
- The decision-making process is fast and automated.
- Quant funds use the best machines, minds, and algorithms to make the most of the market inefficiencies.
- A well-supervised quant fund displays less volatility.
- Quant Funds rely on historical data for investment success.
- They have to be backtested number of times and quite rigorously so until they actually work to meet the desired return.
- They rely on academic researchers’ advice rather than the guidance of skilled live traders, which may result in ambiguous solutions and investment decisions.
- The impact of unforeseen changes is not considered.
- There are a lot of assumptions taken, such as the stock prices, volume growth, and earnings ratio, to be historical, etc.
- Quant funds buy and sell stock only if they meet the predefined conditions. So even if there is a good stock that has not met the volume criteria, the stock would not be bought.
To sum up, Quant funds are those type of funds which may help in the portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio., but they cannot act as substitutes for regular actively traded funds. They can, in fact, as stated above, be considered as funds that are midway between active funds and index funds. Though they are consistent, accurate, and fast, quant funds have a specialized place in the market wherein it is necessary to be aware of the risks involved and the shortcomings attached.
Thus, quant style investing should be mixed with other investment styles and strategies to obtain optimum returns and significant diversification.
This has been a guide to Quant funds and its definition. Here we discuss how do Quant funds work, its example along with advantages, disadvantages, and importance. You can learn more about trading from the following articles –