What's Behind T. Rowe Price's New Quant Funds?

T. Rowe Price has long been known for its bottom-up, analyst-driven research, which is the building block for nearly all of its funds. It has generally done well with that approach across asset classes, equity styles, and market-cap range: Three fourths of its funds ranked in the top third of their respective categories over the past decade.

It was surprising, then, to see the firm launch three new quantitative funds in 2016 under the "QM" (Quantitative Management) moniker: T. Rowe Price QM US Small & Mid-Cap Core Equity TQSIX, T. Rowe Price QM US Value Equity TQVIX, and T. Rowe Price QM Global Equity TQGIX. What’s more, while quantitative funds account for a fairly trivial share of T. Rowe’s assets under management (about $2.4 billion of T. Rowe’s $478 billion in mutual fund assets as of April 2016), the firm has been investing in the capability: Indeed, the quantitative team, led by portfolio manager Sudhir Nanda, is slated to add an eighth member to its ranks in July.

Here's Morningstar's initial read on the effort:

• T. Rowe is evolving its approach, but, rather than giving up on its traditional bottom-up research, it is using quant to complement and enhance it.
• Quant arguably gives the firm more capacity flexibility.
• This initiative also is a clear nod to industry trends and demand and hints at the pressure that traditional active managers like T. Rowe face.
• Thus far, T. Rowe has responded in a way that seems consistent with its identity for reasonably priced, low-turnover investment strategies.
• Its success--or failure--in this endeavor will be especially of interest given that T. Rowe has been a bellwether in other areas such as fund of funds and target-date funds.

Background

Quantitative investing isn't completely foreign to T. Rowe Price: The firm’s flagship quantitative strategy, T. Rowe Price Diversified Small Cap Growth (since renamed

While results were middling in its first several years of existence, it turned a corner once manager Sudhir Nanda took over in 2006 and began applying his own multifactor stock-selection model. Nanda, who was a professor of corporate finance before joining T. Rowe in 2000, focuses heavily on valuation, profitability, and earnings quality. Unlike other quant funds, momentum plays a smaller role as Nanda strives to minimize trading costs with a relatively low-turnover approach.

It has been under the radar for most of its existence, though, as T. Rowe didn’t actively market the strategy; the mutual fund only surpassed $2 billion in assets in 2015, based largely on its impressive risk-adjusted results under Nanda. (Nanda currently runs $4 billion strategywide.) Given that fund's success, the push into quantitative investing isn’t quite the experiment it might appear to be at first glance. That the fund earns a Morningstar Analyst Rating of Silver would seem to bode well for the recently launched funds.

Changing Preferences In some ways, the quant fund rollout signals that T. Rowe is trying to adjust to changing investor preferences. Investors' increasing focus on low-cost passive and strategic-beta strategies presents a particular challenge to the future growth of traditional active managers like T. Rowe. While the firm offers a few index funds, that's not its bread and butter. Thus, the expansion of the QM suite could represent another way for the firm to diversify its asset base while leveraging existing skills and capabilities to appeal to investors seeking lower-cost strategies.

T. Rowe has gracefully adapted to changing industry demands in the past. Beyond its first fund launch (

The Capacity Challenge By the same token, the quant expansion could be another outlet for the firm's remarkable growth, which has come thanks to the broad success of its funds and strong foothold in the U.S. defined-contribution market. Inevitably that growth, which has tripled the firm's mutual fund assets over the past decade, has led to capacity issues. To its credit, T. Rowe has attempted to address that challenge by closing strategies before bloat sets in. For instance, four of its eight actively managed small- and mid-cap strategies are currently closed to new investors. Nevertheless, if the firm succeeds in the future, that success will bring with it pressure to invest larger sums and, in turn, potentially intensify the capacity challenges it faces.

And addressing that challenge is not simply a matter of keeping popular funds closed. T. Rowe's successful target-date series, for instance, has been a huge growth driver for the firm's overall business. Indeed, the firm would have posted net outflows in 2015 if not for the assets its target-date series garnered. The asset growth in the popular target-date series has implications for the underlying funds; all still receive regular inflows despite the fact that five funds are closed to new investors outside the series. T. Rowe has indicated it may incorporate a small/mid-cap index fund in the future to address capacity issues in a relatively low-cost way (the series already uses an S&P 500 fund to keep costs down).

In that sense, the quantitative strategies could offer some respite. They have a broader universe of stocks from which to choose and aren't relying on the fundamental analysts' picks, which potentially means less overlap in holdings with the other T. Rowe active funds. For instance, QM US Small-Cap Growth Equity had 30% of its assets in common with small-growth sibling T. Rowe Price New Horizons as of March 2016. The launch of T. Rowe Price QM US Small & Mid-Cap Core Equity, therefore, is a way to build out the firm's fund lineup in an area that has long faced capacity constraints and has been inaccessible to new T. Rowe investors who haven't been able to buy the closed funds.

QM's Role That begs the question of whether the expanding suite of quantitative funds is destined to play a role in the target-date series. T. Rowe has said it has no plans to incorporate them at this point, but it stands to reason that the flows streaming through the target-date funds inform the way the firm thinks about, and plans for, capacity constraints that could arise in the future. If the new quant funds pass muster, they could be a logical way to help manage future asset growth without having to add more index funds to the series. Or perhaps there will come a day where there's demand for a QM target-date series, whether offered broadly or customized for institutional clients.

Even if the QM funds don’t figure directly into the target-date portfolios, they do seem to represent an acknowledgement of the limits to which scale can be achieved in the traditional active funds. T. Rowe increased its firmwide ownership limit of individual companies to 18% from 15% in 2012 and is already a top owner of many of its best analyst ideas. Money flowing into its funds has to be invested somewhere.

The quantitative model can help in this respect, uncovering new ideas that are not formally under analyst coverage. Each time Nanda invests in a company in his QM fund, the appropriate sector analyst receives a notification. Occasionally during that process a new name is added to analyst coverage, which could benefit some of the fundamental funds. Could output from the quant models simply lead to further crowding in those ideas? So far, that hasn't happened to a significant degree: Nanda reports that recently 28% of the T. Rowe Price QM US Small-Cap Growth Equity's assets were invested in companies rated "buy" by the firm's fundamental analysts; 19% was rated "hold" or "sell"; and 53% was not rated. Furthermore, position sizes in the QM fund are typically capped at 1%, leaving room for ownership by other funds.

The Quant Effect More broadly, quantitative input has crept into T. Rowe's fundamental research process. For each company under coverage, the quant rankings (globally, regionally, and by sector) appear alongside the analyst's research note, and detailed metrics are available to the whole investment team. In many ways, the quant model considers factors that have long been emphasized by T. Rowe's fundamental analysts, including valuation, capital allocation, profitability, and earnings quality. Thus, the rankings can provide a check on the work of the fundamental analysts, perhaps raising a red flag if earnings quality dips.

However, the quant rankings are intended to supplement, rather than override, the analyst's input. Indeed, the analysts can assess the quality of a management team in ways the quant model can't. The model considers blunt outputs, such as dividend payouts and share buybacks, but an analyst's recommendation might hinge on a company's turnaround potential or a strategic initiative, which aren’t reflected in the quant scores. In other cases, the analyst might have a longer time horizon for a holding than the quant model based on how company management is executing.

Even so, Nanda estimates that 70%-80% of T. Rowe's portfolio managers use his team as a resource. During those meetings, he points out portfolio holdings that don't score well on the quant model, which can give the manager broader context because its rankings are global. He may suggest altering the weight of a position, discuss a new idea, or talk about factor bets across the portfolio. Some fundamental managers have embraced the input, even asking quant analysts to sit on the investment committees for their funds.

An Edge? Is the increasing presence of quant investing at T. Rowe--both process- and productwise--simply necessary at this stage, given T. Rowe's asset growth? Or does the firm have a real edge? There are some advantages over other quant funds. Nanda is focused on minimizing trading costs, making incremental trades rather than big moves in and out of stocks, and typically keeps turnover below 30%. And, unlike some quant funds, momentum isn't the main driver of the process, which has helped the fund hold up better during market sell-offs.

The process has worked well at T. Rowe Price QM US Small-Cap Growth Equity for almost a decade, leading to strong risk-adjusted results. (Granted, the fund's small asset base during its existence was an advantage.) The fund had a similar risk profile as its fundamentally driven sibling, T. Rowe Price New Horizons: The QM fund lost 85% as much as the Russell 2000 Growth Index in down markets from Nanda's October 2006 start through May to New Horizons' 82%. Both sat near the top of the small-growth category during that period, with T. Rowe Price New Horizons edging the QM fund by 85 basis points annualized.

Final Thoughts Early results have been good, and T. Rowe has succeeded with new initiatives and funds in the past. However, the stakes may be even higher today, given industry pressure on traditional active managers. There's also no guarantee that the new QM funds will see as much success as T. Rowe Price QM US Small-Cap Growth Equity or that investors will gravitate to these funds. Regardless, T. Rowe is serious about the efforts: Nanda says the size of the quant team could double in a couple of years, which courts risks if the team grows too quickly or doesn't find the right hires.

Even so, the quant avenue seems like a prudent, systematic way for T. Rowe to continue addressing firmwide capacity concerns, all the while providing additional input for the fundamental analysts and managers who choose to use it.