Not the Man, But the Machine

MORE AND MORE MONEY MANAGERS are thinking inside the box. Quantitative mutual funds, dubbed “black box” investments for their strict adherence to quantitative metrics and technical analysis, have come into vogue this year, with firms — both large and small — rolling out or acquiring computer-driven portfolio models to fill product gaps and meet client demand.

Although quants first emerged in the 1970s — born out of the ivory towers of academia — quantitative investing has really hit a growth spurt over the last few years, particularly in 2005. A record 81 quant funds — driven by the demand for ETFs and the fundamental-indexing phenomena — have come to market in 2006, up from 21 in 2005 and only three in 2001, according to Lipper, which launched coverage of quant funds as a screening characteristic in April. Assets held in quant funds tracked by Lipper are approaching $40 billion, up from $19 billion at the end of 2002. Lipper considers a fund to be quantitative if it relies solely on numerical measures versus qualitative ones — meaning that the manager cares less about what business an investment is in and more about what metrics the company's stock displays. Of course, the portfolios are created and managed by computer models.

“For the first time, quantitative investing has become mainstream,” says Bill Zeiff, chief investment officer and managing director of Evergreen Investments. “It has just turned the corner.”

If You Can't Beat ‘Em

The main reason for this shift is that it is very hard to beat the market. So it makes sense to buy exposure to an index as cheaply as possible and to buy alpha in less efficient sectors, known as the core-and-explore strategy. As individuals become more like institutions in their investing tastes, they are adopting many of the same models.

“It's one of the good, solid trends out there,” says Christopher Donahue, CEO of Federated Investors. “It will increasingly resonate with advisors across the board.”

The performance of these quant funds doesn't hurt either. In the past five years, they have returned an average of 6.95 percent a year across various asset classes, according to fund research firm Lipper, versus 5.93 percent for all actively managed U.S. stock funds. Further, a study of managed accounts and commingled funds by Casey, Quirk & Associates, a management-consulting firm in Darien, Conn., showed that active U.S. large-cap equity quant products have outperformed other active U.S. large-cap equity products by 103 basis points over the three-year period through 2004. Recently, quantitative vehicles have been enjoying greater asset growth than their actively managed counterparts. As of year-end 2004, the 70 quantitative products that had an established track record managed $157 billion, nearly double the assets from three years earlier when they stood at about $88 billion, at an annualized rate of 21 percent over three years through 2004. By comparison the assets in non-quant products increased to $925 billion from $720 billion, a 9 percent increase. Yet, quantitative investing accounts for 16 percent of actively managed assets in the U.S., up from 13 percent in 2003, according to Vanguard.

There are also a number of other favorable trends underpinning the quant movement, analysts at Putnam Lovell NBF Securities say: Vastly improved computing power has lowered the price of creating them, thus putting quant models within reach of smaller fund managers. Retail investors' increased interest in alternative-investment strategies has also been a boon for quant investing, because many quant shops use absolute return strategies or some sort of short-selling component.

The memory of a painful bear market still weighs on the minds of retail investors, who have come to regard the risk management of some quants as more rigorous than their actively manage counterparts. It's the quant models' systemized investment strategies (put another way, their “leave-emotions-out-of-it-please” style), which for years attracted institutional investors, that is now trickling down to the retail set.

Then there are the lower fees. Many quant strategies — particularly the passive computer models that drive ETFs and indexing-based funds — charge lower fees and expenses than traditional actively managed rivals, since, well, they obviously have fewer research personnel and fewer star stockpickers to pay. Indeed, the average expense ratio for a quant fund is about 1.32 percent, as compared to 1.46 percent for the average, actively managed U.S. equity fund, by Lipper count.

While a variety of fund flavors have fallen in and out of favor over the years, some big managers are betting that quant funds will stick. Vanguard, Federated, Janus, American Century, AllianceBernstein, Evergreen and Schwab have each rolled out quantitative products in the past few years, either through acquisition or from scratch. They join the likes of Barclays Global Investors and LSV Asset Management, which are the biggest players in the quant space. Numeric Investors and AQR Capital Management are among the fastest-growing quant shops in the market.

Buying Frenzy

With favorable conditions for quants at their back, buyers have emerged in droves. In July, Federated closed its $240 million acquisition of privately held MDT Advisers, a boutique quant shop in Cambridge, Mass. MDT has $7 billion under management — nice but not great given its 18-year history. Federated, which has been somewhat mediocre of late, gives MDT a strong retail distribution network in exchange for instant credibility on the institutional side. “MDT is listed in places we're not, such as Smith Barney, Merrill Lynch and UBS. They have 10 different mandates, a host of SMA products and great performance,” Donahue says.

In February, Janus Capital raised its stake in Enhanced Investment Technologies, or INTECH, an institutional quant shop based in Palm Beach Gardens, Fla., to 83 percent. The overall stake is worth $1.8 billion and represents 40 percent of Janus' $4.4 billion market capitalization. Janus is still struggling to repair its tarnished image, and INTECH has helped. The quant subsidiary posted net inflows of $2.6 billion in the second quarter of this year compared with Janus' net outflows of $3 billion for the quarter. Experts say that money managers have witnessed INTECH's strong performance and may be trying to mimic its success.

In 2000, Schwab introduced a series of quant funds when it purchased Chicago Analytics, a small quantitative research firm that now powers its research department. The results have been stellar. Barron's awarded a model portfolio that uses Schwab's “equity ratings” strategy, which is based on Chicago Analytics' method, first place for the most recent five-year period. Recently, Schwab added three new quant funds to bring its total to 20, including proprietary and subadvised funds. Analysts expect the deal activity to continue. “We might see more of those deals,” says Daniel Celeghin, associate director at Casey, Quirk & Associates. “The demand is there.”

Others have gone the organic route. In June, American Century launched three new quant offerings to its lineup, bringing its total to 10 funds. Evergreen has been using quantitative methods in its global structured products unit since 2000, and AllianceBernstein has been bringing quant funds to market as well. Vanguard introduced its Strategic Small-Cap Equity fund in April, giving it seven quant funds, but it farms out oversight of some its funds to a trio of Boston quant specialists including Acadian Asset Management; Grantham, Mayo, Van Otterloo; and Franklin Portfolio Associates.

Critical Math?

Despite its recent popularity, not everybody is convinced that quants will have lasting success in the retail world. “It's been much more of an institutional phenomenon,” says Celeghin. “The product characteristics are anything but retail.”

Some argue that quant funds are human-based in the first place — personal bias supported by data mining anchored by flawed back-testing. Besides, what has worked in the past won't always work in the future, no matter how well conceived (exhibit A, the Long-Term Capital Management debacle).

Others say the methodology is not transparent; many quant skippers withhold portfolio information and do not disclose the criteria on which their models are based — making investing in them something akin to an act of faith. Some funds decline to divulge their secret recipe for fear of being copied, while others say the strategies are not easily understood by the average advisor much less the average investor. The more complex quant strategies evaluate stock based on up to 75 data points. “Traditionally, the fundamental story sells much better,” Celeghin says.

For now, quant has momentum. Clearly, manufacturers of asset management are actively pushing quant products on advisors. But the question remains whether or not quantitative vehicles should be part of a core asset-allocation strategy. And if performance stays hot, and money managers continue to whet advisors' appetite for lower risk and alternative strategies, these computer-driven models will thrive. A continued focus on the institutional process among the major wirehouses could be an indication that these machines will stay well-oiled.