What are Quant Funds?

Quant funds, also known as quantitative funds, are investment funds in which investment selection and related decisions are taken not with the help of human intellect and judgment but by analytical methods and advanced quantitative analysis.

Explanation

Inactive funds, the fund manager, makes decisions about the timing of entry and exit of the investments, which is not so in the case of quant funds, wherein numerical methods, automated programs, and quantitative models are used to make decisions about the same. But that doesn’t mean a quant fund manager would have his hands off like an index manager. Here the fund manager would still be responsible for monitoring the quantitative/ arithmetical/ analytical model that comes up with the portfolio choice.

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How Does a Quant Fund Work?

Example of Quant Funds

Let us consider the example of the DSP Quant Fund. This fund chooses stocks with high return potential and consistent earnings. Thus, while selecting stocks, the stocks of companies with high leverage and volatility would be eliminated.

  • Input System In this step, inputs are provided to the system. Companies with good factors such as Dividend yield, earnings growth, return on equity, free cash flow yields (FCFY), etc., are chosen without bias, and the stocks of companies with high risk, high debts, stocks with high volatility, and inefficient capital allocation are eliminated. That means long-term denigrators of alpha are done away with, and durable sources of alpha are selected. Forecasting System This step generates estimates and forecasts regarding the prices, risks, returns, and other factors. The evaluation of stocks is done at this stage. Portfolio Construction After inputs are entered and forecasts are generated, a piece of portfolio advice is constructed. Each stock selected is given appropriate weights so that risk is reduced to an acceptably low level, and returns would be as desired. That means an optimum portfolio shall be constructed in this stage.

In this step, inputs are provided to the system. Companies with good factors such as Dividend yield, earnings growth, return on equity, free cash flow yields (FCFY), etc., are chosen without bias, and the stocks of companies with high risk, high debts, stocks with high volatility, and inefficient capital allocation are eliminated. That means long-term denigrators of alpha are done away with, and durable sources of alpha are selected.

This step generates estimates and forecasts regarding the prices, risks, returns, and other factors. The evaluation of stocks is done at this stage.

After inputs are entered and forecasts are generated, a piece of portfolio advice is constructed. Each stock selected is given appropriate weights so that risk is reduced to an acceptably low level, and returns would be as desired. That means an optimum portfolio shall be constructed in this stage.

The main motto of such funds is three folded:

  • Buying good stocks at reasonable pricesHolding such stocks for right periods andRemaining unbiased and not attaching emotion while investing.

The three-step process (input- forecasting- elimination) is followed above. In the first step, 80-100 companies are eliminated, and the stocks selected are tested for the factors such as growth, potential, returns, etc. Then weights are allocated so that there is proper diversification and also reduction of stock and sector concentration so that no stock can occupy more than 10% of the entire stock, and the weight of any sector shall also be around 10%, nothing much higher.

Importance of Quant Funds

Investing in Quant funds is essential because they reduce human biases and build a portfolio by adhering to the basic rules of investing tested over the market cycles, keeping it simple with minimal human interference. The basic rules of investing are buying stocks of good companies, not overpaying for the same, and being unbiased, which are the rules exactly followed by the Quant funds managers.

Advantages

  • Such types of investmentsTypes Of InvestmentsStocks, bonds, and cash equivalents are the three main forms of investments. Investment, in general, refers to the purchase of anything for future use with the goal of generating a regular cash flow or increasing the value of something over time so that it can be sold for a higher price than it was purchased for, i.e. capital gains. read more would eliminate human bias and prejudice.The expenses are lower than those of active funds because a passive and consistent strategy would be followed.Usage of a model permits consistency in the investment strategiesInvestment StrategiesInvestment strategies assist investors in determining where and how to invest based on their expected return, risk appetite, corpus amount, holding period, retirement age, industry of choice, and so on.read more across all market conditions and, as a result, the risk controlRisk ControlRisk control basically means assessing and managing the affairs of the business in a manner which detects and prevents the business from unnecessary calamities such as hazards, unnecessary losses, etc. that may occurread more would be superior.The occurrence of errors would be reduced drastically.Human emotion, fatigue, etc. would not affect the investment as minimal human intervention exists.The decision-making process is fast and automated.Quant funds use the best machines, minds, and algorithms to make the most of the market inefficiencies.A well-supervised quant fund displays less volatility.

Disadvantages

  • Quant Funds rely on historical data for investment success.They have to be back tested several times and quite vigorously so until they work to meet the desired return.They rely on academic researchers’ advice rather than the guidance of skilled live traders, which may result in ambiguous solutions and investment decisions.The impact of unforeseen changes is not considered.There are a lot of assumptions taken, such as the stock prices, volume growth, and earnings ratio, to be historical, etc.Quant funds buy and sell stock only if they meet the predefined conditions. So even if a good stock has not met the volume criteria, the stock would not be bought.

Conclusion

To sum up, Quant funds may help in portfolio diversificationPortfolio DiversificationPortfolio diversification refers to the practice of investing in a different assets in order to maximize returns while minimizing risk. This way, the risk is kept to a minimal while the investor accumulates many assets. Investment diversification leads to a healthy portfolio.read more, but they cannot act as substitutes for regular actively traded funds. They can, as stated above, be considered funds that are midway between active and index funds. Though they are consistent, accurate, and fast, quant funds have a specialized place in the market, wherein it is necessary to be aware of the risks involved and the shortcomings attached.

Thus, quant-style investing should be mixed with other investment styles and strategies to obtain optimum returns and significant diversification.

This has been a guide to Quant funds and their definition. Here we discuss Quant funds work, their example, advantages, disadvantages, and importance. You can learn more about trading from the following articles –

  • Trust Fund TypesExchange Traded Funds TypesBalanced FundsWhat are Mutual Funds?