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Our Favorite Quant Funds

Can a computer pick stocks better than an active manager?

Reginald Laing, 07/18/2006

By now you've probably heard that a majority of mutual fund managers fail to beat broad market indexes. But if most managers have a poor stock-picking record, can computers succeed where they fail? Computers now can beat grandmasters at chess, so shouldn't a manager be able to harness their incomparable powers of calculation to outperform even the best human stock-pickers? Fund managers who employ so-called quantitative strategies would answer "yes" to these questions. These managers use sophisticated computer models to pick stocks and bonds that the models predict will have market-beating returns.

Quant funds have a lot of intuitive appeal. First, they strip away at least some of the human bias that trips up active managers, who often buy into market trends at precisely the wrong time and overlook real values. Also, quant models allow a manager to sift through thousands of securities and pick out ones that have the characteristics, or factors, he thinks are predictive of high future returns. What takes a model minutes to compute would take a team of analysts weeks--time for market conditions to change and discovered opportunities to disappear. Moreover, managers who have faith in their quant models are unlikely to deviate from their strategies, thereby avoiding the inconsistency that hurts many active managers.

Before proceeding, we should note that the line between quant funds and traditional actively managed offerings is blurry. Many, if not most, nonquant funds use computer models to narrow down their investment universes, so that analysts can focus their research on a manageable number of stocks. Quant funds are not immune to human error. After all, people build the quant models, and, after they're built, the models are rarely static. Most successful quant managers are always looking to maintain their edge versus the market by seeking out new factors to replace ones that have lost their predictive power. For that reason, quant funds can, and often do, have many of the faults of their human creators.

Still, a quant fund can be a good addition to a portfolio. (Consider placing it in a tax-sheltered account, though, as these funds often trade a lot.) And in selecting one, all the usual rules apply for choosing a fund. Investors should look for ones that follow disciplined strategies, have successful track records in a variety of market conditions, and charge low fees. A low expense ratio is particularly important, as quant funds tend to resemble their benchmarks, holding a sizable number of stocks and keeping sector weightings close to those of the benchmark. That controls risk, but it also limits gains, so low fees are essential if the fund is to edge past its benchmark.

Here are descriptions of three of our favorite quant funds:

Vanguard U.S. Value VUVLX
This fund represents the cheapest way (expense ratio: 0.39%) for retail investors to gain access to the highly regarded quant team at institutional manager Grantham, Mayo, Van Otterloo & Co. For this fund, GMO uses three separate models to rank the stocks in the Russell 3000 Index. The first model looks for stocks trading at deep discounts to their intrinsic values, using metrics such as return on equity. The second model flags stocks that are trading at discounts to the broader market, and the third looks for companies showing earnings and price momentum. Stocks with high composite scores enter the portfolio, while stocks with lower scores drop out. The two models that pick stocks based on valuation give this fund an overall value tilt, while the momentum model is meant to ensure that stocks with slowing fundamentals--and falling share prices--don't enter the portfolio. The momentum screen also serves to diversify the portfolio, so it can still compete when value cools off and growth takes the lead.

Bridgeway Large-Cap Growth BRLGX
Quant extraordinaire John Montgomery runs this fund using models he developed when working as a transportation engineer and buying stocks in his off hours. It isn't as famous as its highly successful mid-growth sibling, Bridgeway Aggressive Investor 1 BRAGX, but the latter fund is closed to new investors and so doesn't make our list. Plus, this one will be better-positioned if market leadership rotates to larger stocks. Like many quant managers, Montgomery is tightlipped about his models, so we don't know what precisely makes them work. But work they do. While this fund doesn't have a three-year record, its one-year return beats those of a majority of its peers. It's also tamer than Montgomery's other funds. Lower volatility and portfolio turnover will make it more palatable to risk- and tax-conscious investors. Finally, it boasts a reasonable 0.84% expense ratio, which is well below the 1.0% median for similar large-cap funds. Unencumbered by high fees and driven by a quant strategy that's proved its mettle in mid- and small-cap stocks, this fund could be a long-term winner.

Janus Adviser INTECH Risk-Managed Growth JDRAX
This fund's model draws on a theorem that manager Robert Fernholz proved while teaching math at Princeton. Without delving too deeply into the arcana, Fernholz's theorem shows that a portfolio of volatile but uncorrelated stocks will produce returns that exceed those of the market. If you buy a basket of such stocks, you can reduce their overall volatility and produce excess returns by continually re-establishing the optimal portfolio, which often means taking small profits in stocks that rise in price and putting the proceeds into those that drop. A manager must limit trading costs to come out ahead, however, and this fund's management team has succeeded at doing so. While the fund hasn't been around for very long, its separate-account sibling boasts a strong 10-year record. What's more, the retail version's 0.86% expense ratio is quite cheap for a front-load large-cap offering. For investors working with an advisor, this fund merits a look.

Honorable Mentions
Many of our other favorite quant funds are closed to new investors. Although we excluded them from our list for that reason, they still deserve honorable mentions. These are the aforementioned Bridgeway Aggressive Investors 1 BRAGX, Bogle Small Cap Growth BOGLX, GMO Emerging Markets III GMOEX, and N/I Numeric Investors Small Cap Value NISVX.

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