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Are Quant Funds Back to Stay?

These funds are largely in recovery mode.

Greg Carlson, 01/14/2013

Funds that use quantitative stock-picking models have spent the past three years trying to climb out of the deep hole they dug for themselves in the October 2007-March 2009 bear market and the early stages of stocks' ensuing rebound.

In the volatile period from late 2007 to the end of 2009--and beyond, in some cases--most quant funds struggled mightily. Their models often rely to a significant degree on earnings or price momentum measures, which caused the funds to build ever-increasing stakes in the hottest areas (such as energy and homebuilders), which then got slammed in the bear. Quant funds that make heavy use of valuation models, however, gravitated to financial stocks--many of which looked cheap on an absolute basis after their initial declines in late 2007 and early 2008--right before that sector plunged. To make matters worse, many quant funds then scooped up defensive fare such as consumer goods makers in the depths of the bear market, as they had the strongest relative earnings momentum at that time. Those stocks were then left behind when the market took off again in March 2009.

Quant funds' misfires were reflected in their returns. A group of 57 quant funds that Morningstar compiled had median return ranks within their categories of 67 (in other words, the bottom third) in 2007, 56 in 2008, and 58 in 2009--and those numbers looked worse before several struggling quant funds were recently merged away or liquidated.

On the Comeback Trail
Performance has since improved. Our quant fund group posted a median category rank of 47 (just above average) in 2010, 30 in 2011 (the group's best year since 2002), and 41 in 2012. Through the end of 2012, the group had beaten 70% of its respective peer groups, on average, for the trailing three years.

Several factors account for quant funds' reversal of fortune. First, the stock market has had fewer twists and turns lately. True, stocks went down at times in each year from 2010 through 2012, but these downturns were generally milder in nature and typically lasted no more than a couple of months. As a result, momentum-based quant models have had an easier time of it. Second, some quant investors--most notably John Montgomery of Bridgeway, which offers six all-equity funds that rely on quant models--have argued that much of their struggle owes to markets driven by macroeconomic concerns (rather than company fundamentals). Macro factors have in turn caused periods of high correlation among stocks to occur far more frequently than in the past. Montgomery says that problem hasn't abated yet, but he notes the firm's funds have had a recent stretch or two without correlation spikes to trip them up. From the end of June 2010 through the end of June 2011, for example, Bridgeway Aggressive Investors 1 BRAGX, the firm's flagship fund, gained 40.8%, beating 85% of its mid-blend peers and trouncing its S&P 500 Index benchmark.
Quant funds' resurgence can also be partially attributed to their previous decline. Because of liquidations and redemptions, there are now fewer quant mutual funds (and hedge funds) with fewer assets. Indeed, our group of quant funds has shrunk to 57 from 65 over the past 2.5 years. This thinning of the herd should result in less strategic overlap--quant factors often lose their edge when too much money chases the same stocks.

Bridgeway and Goldman Retool
Successful quant investors typically tweak their models on an ongoing basis. But two firms that manage a significant number of quant mutual funds, Bridgeway and Goldman Sachs Asset Management, have made substantial efforts in the past several years to refine their strategies. Each has eliminated or reduced the weightings of less-effective models and developed new measures. Bridgeway in particular has re-engineered its models in an attempt to perform a bit better in high-correlation environments, although Montgomery stresses the firm didn't make wholesale changes to optimize its strategies for past difficult periods. (These efforts were completed near the end of 2011.) Meanwhile, Goldman's quant team has seen significant personnel changes, and its new leader is incorporating new measures such as models that spot key words in reports and press releases and a shorter-term return forecasting model for stocks.

It's too early to predict the long-term impact of these firms' efforts to improve performance. But Bridgeway had a solid 2012; three of its six all-equity quant funds ranked in the top 15% of their respective categories (only one lagged its typical peer), and Montgomery says the funds held up better than usual when correlations rose in 2012's second quarter. Goldman's quant funds, meanwhile, posted middling returns, but that firm's changes are still being implemented.

What Now?
Quant funds have made up some of the ground they lost to their peers during the downturn and 2009's dramatic recovery. Over the trailing five years through Jan. 7, 2013, their median category rank is 51, which puts them right in the middle of the pack. However, when 2007's subpar showing is included, only a fourth of the group has beaten its typical peer over that six-year span.

It is difficult to be confident at the moment in many quant funds' long-term prospects given the extent of their previous struggles and some funds' recent changes. Indeed, of the seven funds in our quant fund list that are currently rated by Morningstar analysts, five earn an Analyst Rating of Neutral, one earns a Bronze, and one earns a Silver. The latter fund, Bogle Small Cap Growth BOGLX, has made only minimal strategy changes lately, as the fund's valuation model helped it recover from the quant malaise more quickly than most. In addition, the firm has kept the fund small and flexible. Bronze-rated AQR Momentum AMOMX, meanwhile, is newer but provides cheap access to a passive and effective momentum strategy. Tread carefully through the rest of the quant fund universe.


Greg Carlson is a fund analyst with Morningstar.

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