NEW YORK ( TheStreet) -- Quantitative funds disappointed investors during the financial crisis. The funds use computer programs to pick stocks, and the systems failed badly in 2008 and 2009. But this year, the computers are back on track, and many quant funds rank in the top quarter of their categories. A leader is Vanguard Strategic Small-Cap Equity ( VSTCS), which has returned 11.5% this year, outdoing 96% of its small blend competitors. Other funds with strong results include Bridgeway Small-Cap Value ( BRSVX), Flex-funds Quantex ( FLCGX), Fidelity Disciplined Equity ( FDEQX) and JPMorgan US Small Company ( JUSSX). Picking a quant fund is not easy. Concerned about maintaining their competitive edges, managers rarely provide more than general details about the screens that they use. To pick likely winners, look for funds with low expenses and strong long-term records. A fund that fits the bill is Bridgeway Aggressive Investors 1 ( BRAGX), which returned 11.1% annually during the past 15 years, outdoing 96% of its mid-cap growth competitors. Another winner has been Vanguard Strategic Equity ( VSEQX), which has returned 9.0% annually for the past 15 years, outdoing 63% of mid-cap blend peers. Quant investing became popular in the 1990s when physicists and mathematicians left college campuses and headed for Wall Street. The quants boasted that they could use their formulas to pick winning stocks. Hedge funds hired the academics, and some of the systems racked up huge profits. But enthusiasm for computerized trading waned when Long-Term Capital Management, a quant hedge fund, exploded in 1998. After markets calmed, institutions again embraced quant managers, pouring billions of dollars into the computerized strategies. The recent poor results can be traced to the computer models. Many quants follow momentum strategies, buying stocks that have rising prices or accelerating earnings. Stocks that did well in the recent past will continue shining, the quants argue. Other quant strategies emphasize undervalued stocks with improving earnings. As the financial crisis unfolded, none of the models worked. Momentum stocks suddenly crashed. In 2008, value stocks of all kinds collapsed as panicked investors sold shaky companies and gravitated to Treasuries and high-quality stocks. In 2009, the direction shifted violently. Stocks that had been on the verge of bankruptcy came back to life. Companies that had fared poorly in 2008 recorded huge gains during the rebound. That undermined momentum strategies. Stocks with rising earnings trailed companies with no profits at all. Quants were left scratching their heads. "The worse a company did, the more it was rewarded," says John Montgomery, a portfolio manager for Bridgeway Funds.
All the turmoil hurt quant managers and left the funds with uninspiring long-term records. Many investors have been dumping the funds and looking elsewhere. But fund companies argue that quant funds are positioned for a period of outperformance. "There is now a bit of a tailwind for quant strategies," says Ted Dimig, a senior client portfolio manager with J.P Morgan. Dimig says that quant funds do best when markets are relatively steady with moderate or low levels of volatility. During such calm periods, momentum screens work because there are no sudden shifts of market sentiment, and strong-performing stocks continue leading the market. In recent months, the steady environment has proved ideal for momentum screens. Quant screens that emphasize healthy earnings and low prices have also been rewarded recently. If markets remain relatively steady this year, then quant funds will continue to excel. Dimig says that quants also have an advantage now because so many competitors have left the markets. After peaking at $1.8 trillion in 2007, assets in institutional quant strategies have fallen more than 50%, according to eVestment Alliance. With fewer competitors still on the playing field, it is easier for managers to take advantage of mispriced stocks. Whether the market conditions prove favorable in coming months, quant funds are worth holding because they can diversify portfolios, says Russell Investments. Russell says that quant portfolios sometimes excel when conventionally managed funds are delivering mediocre results. For the three consecutive years that began in 2004, quant funds rallied and outpaced conventional funds as well as the Russell 1000 benchmark. Starting in 2007, the winds shifted and quant managers had a prolonged period of underperformance. Russell says that the lack of correlation occurs because quants tend to favor value stocks. Those did well early in the decade and lagged in recent years.
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