India is ready for quant investing

With a global share of 15 per cent of assets under management (AUM), actively managed quant funds are an accepted style of investment management. The use of quantitative methods in stock selection and portfolio construction has been well established globally but these funds are still relatively new to India. They are, however, expected to grow as investor awareness increases in the days to come.

Most quant funds fall into one of two simple categories. The first is made up of those use computers to replicate the investment process followed by a conventional fund manager, focusing on fundamentals such as value, growth and quality of the business or technicals such as price patterns. Conventionally, such investors are called factor investors. The logic behind stock selection is open, but the selection process is proprietary.

The second category of investors use “black box” models, where neither the logic used nor the process is public. For these managers, the track record of their funds is the sole barometer that the investing public has to judge the quality of their processes.

The benefits of quant investing are consistent performance that is independent of a single fund manager, well understood and documented risk management that reduces the risk of a “blow up”, a process that can adapt to varying market conditions and lack of behavioural biases or emotion-led decisions

Assessing risk tolerance

Investors in these funds believe that in India a series of factors that can be captured by computers can be used to construct portfolios that offer robust performance at lower risk levels. Their processes consist of the following steps:

To begin with, quant funds carefully define the objectives and risk tolerance of a fund. The second step is to construct a “universe” of stocks for every fund based on the databases built up. This database needs to have clean data, be free of potential pitfalls like survivorship biases, bonus issues and rights issues, and must incorporate a wealth of data on a wide variety of companies. Our databases cover over 50 line items for 500 companies across 12 years.

The portfolios are then constructed based on the historical performance of factors relevant in India. The exact processes are proprietary but the core factors are well understood and accepted. The top 500 companies by market cap are evaluated on such factors as value, growth, volatility and price performance, to avoid reliance on any single factor. A consolidated score is arrived at for each company that is used to generate a list of companies for inclusion in the portfolio.

Finally, the portfolios are analysed for risk factors to make sure that performance is within boundaries understood and accepted by investors. After the portfolio is invested into, the investment management team closely monitors funds and performance to make appropriate changes as and when required.

Alert to changes in valuation

Markets evolve, and so do our models. As the competition for performance heats up, only managers with a superior process for collating and analysing information or a distinct method of delivering returns will succeed. Any quant team has to stay on its toes, looking for “fade out” in some factors and a resurgence in others.

Our preferred version of a quant is not a blind or slavish dependence on computers. Rather, it involves continuous development of key insights into stock performance that are rigorously tested and applied to a wide variety of stocks. Discipline and high quality processes are key to successful asset management, and quantitative fund management is one way of making sure these are applied to portfolios.

The quant approach is often misunderstood. At times, investors make the mistake of holding quant investing to an impossible standard since computers are at play or believe that quant investing cannot work in countries like India. Data and several tests have shown that quant investing does work in India and can offer returns that match, and often beat, high-class Indian fund managers. The true charm of the quant process is that the performance of quant funds is not highly correlated to that of traditional fund managers and, hence, inclusion of these funds in a portfolio adds significant value to investors.

(The author is the Chief Executive Officer of Edelweiss Asset Management Limited. The opinions expressed are his own.)

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