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Is the Quant Fund Rally Fading?

Solid choices remain even if their hot streak cools down.

Quantitative funds such as Bridgeway Small-Cap Growth BRSGX have been red-hot, but the good times may be over. Funds that employ quantitative stock-picking models do best in nice steady environments when company fundamentals work well at signaling where a stock is headed. That's why quant funds have looked great during the past three and five years, but have fallen back into the pack during the market's recent decline. A list of 66 quant funds compiled by Morningstar beat at least 60% of their respective Morningstar Category peers, on average, in each calendar year from 2011 through 2015. This hot streak follows a brutal stretch from 2007-10 when the stock market plunged sharply then quickly reversed course and spiked upward. In keeping with this trend, quant funds posted a very average category rank of 48 during the three months ended March 10, 2016, as stocks generally dropped.

Beyond their use of models, quant funds don't have much in common. Thus, they can be difficult to identify as there is no portfolio or return data point that indicates a fund uses quant models. Also, a fund isn't required to disclose in its prospectus that it does this, and the names of quant funds rarely tip off investors, either. Morningstar's list of quant funds is based on our manager research analysts' knowledge of money management firms, portfolio managers, and strategies.

A Resurgence Many quant funds rely in part on models that identify companies with upward earnings or stock-price momentum, which in turn has influenced the group's performance pattern: Strong returns in markets that rise in a fairly smooth fashion, and average or poor showings when stocks change direction quickly. Trailing return ranks bear this out: During the past three and five years, the typical quant fund on our list surpassed more than 80% of its peers. However, it all goes haywire in a bear market. During the past 10 and 15 years--periods that incorporate one and two bear markets, respectively--these funds' median category ranks drop to a fairly ordinary 46 and 43. The aforementioned Bridgeway Small-Cap Growth is a prime example. The fund has beaten more than 90% of its category peers over the trailing three and five years, thanks in part to thriving in 2013's big rally. However, it underperformed in the October 2007-March 2009 bear market, and lagged badly in 2009 when stocks rapidly rose after the market bottomed. Thus, the fund trailed more than 90% of its peers during the past decade. It's important to note that our performance figures don't include poor-performing quant funds that were merged away, liquidated, or changed to a more standard fundamental approach.

Other possible factors behind the strong performance of the past few years: Competition decreased following the October 2007-March 2009 bear market as investors pulled their money from quant mutual funds as well as quant-oriented hedge funds, some of which liquidated following severe losses. Also, some struggling teams tweaked their strategies and have since enjoyed rebounds, including Bridgeway (which has seven actively managed quant funds, including two American Beacon funds that the firm subadvises) and Goldman Sachs' quant team. (That said, these revised approaches haven't been tested by a bear market, although Bridgeway Small-Cap Growth has held up well thus far in 2016's turbulence.) Meanwhile, AQR, a quant firm that initially ran hedge funds, has rolled out a series of modestly priced mutual funds in recent years that have met with success.

A Turnaround in Flows Investors have responded to quant funds' improved performance with some enthusiasm: The typical fund on our list saw modest net inflows for the trailing year through February 2016. That's noteworthy given the migration of cash from actively managed funds to passive options in recent years. The two funds that have drawn the most cash in recent years have been Undiscovered Managers Behavioral Value UBVLX and American Beacon Bridgeway Large Cap Value BRLVX, which have posted stellar returns over three, five, and 10 years.

Our Recommendations

But the overall quant fund universe is still relatively small; the largest fund on our list,

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