Quant Mutual Funds Top the Benchmarks

NEW YORK (TheStreet) -- Many quantitative mutual funds delivered winning returns in the past year. The funds use computerized models to pick stocks, and lately the models have been on target. Funds that outpaced their benchmarks by wide margins include Bogle Small Cap Growth (BOGLX) and Bridgeway Aggressive Investors (BRAGX).

The strong performance represents a big change from what occurred in the meltdown of 2008, when many quant funds lagged badly. During the turmoil, portfolio managers said that their systems failed because panicked markets did not distinguish between promising stocks and those with unattractive characteristics. The managers assured shareholders that the funds would revive when markets calmed.

Now that the panic selling has abated, the quant systems seem to be functioning better. "Our funds tend to do well in environments where investors are thinking in disciplined ways," says John Ameriks, a principal at Vanguard who oversees the company's quantitative funds.

Some of the best showings have come from small-cap funds. Quant funds that have topped the benchmarks include Fidelity Small-Cap Enhanced Index (FCPEX), TFS Small-Cap (TFSSX) and Vanguard Strategic Small-Cap Equity (VSTCX).

Famous for its index funds, Vanguard has enjoyed notable success with its actively managed quantitative funds. During the past five years, Vanguard Strategic Small-Cap returned 22.4% annually, topping 75% of small blend peers and outdoing iShares Russell 2000 ETF (IWM) by a percentage point, according to Morningstar. Besides overseeing the small-cap fund, the Vanguard managers use their quantitative models to run Vanguard Strategic Equity (VSEQX), which has outdone 82% of its mid-cap blend peers in the past five years.

Holding about 400 stocks, the Vanguard small-cap fund aims to outdo its benchmark, the MSCI US Small-Cap 1750 Index. The quant model emphasizes undervalued companies with the potential to deliver future earnings growth. The system favors stocks with healthy balance sheets and consistent cash flows.

The current portfolio holdings have an average price-to-earnings ratio of 21, compared to 29 for the benchmark. The holdings have been increasing earnings at a 14% rate, compared to 10% for the benchmark. To limit the risk of underperforming, the managers keep many of the portfolio's characteristics roughly in line with the benchmark. The sector weightings are close to the figures for the index.

Should shareholders dump their Vanguard index funds and shift to the company's quant offerings? No, says Vanguard's John Ameriks. "For core holdings, indexing is a great way to go," says Ameriks. "If you want to try to do better than the benchmark, then a quantitative fund can complement the core holding."

Among the top quant performers is TFS Small Cap. During the past five years, the fund returned 27.5% annually, outdoing 98% of small blend peers. The TFS portfolio managers also use their quant models to run TFS Market Neutral (TFSMX), a steady fund that has returned 5.4% annually during the past five years, outdoing 78% of market neutral peers.

The TFS managers run several different models. One model emphasizes stocks with attractive fundamental characteristics, such as low prices and strong earnings. Another model tracks the so-called smart money, buying stocks that are favored by investors with successful track records. Each model is used to manage a separate pool of money. The pools are combined in one mutual fund portfolio. "If one model is doing poorly, it may not hurt the other models," says portfolio manager Eric Newman.

Newman cautions that the TFS managers often trade rapidly. That can result in taxable short-term gains. To control costs, he suggests holding the fund in a tax-sheltered retirement account.

Fidelity Small Cap Enhanced stays broadly diversified, holding about 500 stocks. The model favors undervalued stocks with high returns on equity and strong earnings growth. During the past five years, the fund returned 21.4% annually, outdoing 62% of peers. When markets turn rough, the portfolio managers aim to limit losses by emphasizing low-volatility stocks. "We are able to shift factors as the environment changes," says portfolio manager Maximilian Kaufmann.

The Fidelity fund tends to hold high-quality stocks. That helped limit losses in 2008 and enabled the fund to outdo most peers for the year.

At the time of publication, the author held no positions in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.


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