Mutual funds managed by computer - sad

Discussion in 'Trading' started by RedDuke, Apr 6, 2006.

  1. Below is an article from today’s Wall Street Journal.

    The two quotes in particular caught my attention:

    Besides greed, I do not understand why someone, who just wants to buy and hold, would invest into something like this. It has been proven clearly that just buying and holding S&P is one of the best, if not the best, option for couch potatos. And to think that PC can outperform it, yeah right.

    Investing into something without understanding it is beyond my comprehension. Then again, I know many traders who open accounts without reading customer agreements, and the excuse I hear, “why bother it is standard”.


    Meet your new fund manager: a computer.

    Mutual-fund companies increasingly are rolling out new funds that dispense with hands-on fund managers and instead rely on computers to select stocks. While so-called quantitative funds have been around for years, they are multiplying now as fund companies seek to boost performance while at the same time cutting costs. Quant funds, as they are commonly known, offer fund companies the chance to outpace market indexes without paying an experienced stock-picker to circle the globe.

    Janus Capital Group Inc., which has long touted its managers' rigorous company research, recently launched Janus Adviser INTECH Risk-Managed Value fund, bringing to six its U.S. quant-fund lineup. Firsthand Capital Management Inc., known for its high-flying, research-driven tech funds during the Internet boom, recently came out with its first quantitative funds. And Charles Schwab Corp. added three new quant funds, for a total of 20, and is planning a quant foreign-stock offering called Laudus Rosenberg International Discovery fund. Its year-old Schwab Premier Equity fund now has $1.4 billion in assets and is about to close to new investors.

    Quant funds first emerged in the 1970s and became popular in the 1990s as computing power increased. Each fund has proprietary computer models that process all sorts of data relating to a stock, such as projected earnings growth, price-to-earnings ratio and past stock-price performance. Since quant funds can analyze thousands of stocks at a time, they often hold broadly diversified portfolios with hundreds of names. In a traditional mutual fund, managers analyze these same data, but also typically study more subjective areas such as a company's products, competitive position and management team before buying its stock.


    Mutual-fund companies are launching more quantitative funds, which rely on computers to select stocks. Here's what to consider:
    • Quant funds and analyze thousands of stocks quickly, and they often hold broadly diversified portfolios.

    • The funds typically have lower expense ratios than traditional actively managed funds.

    • Frequent stock trading by quant funds could leave investors with higher tax bills from capital gains.

    Investors are attracted to quant funds for their non-emotional, disciplined method of investing. Some investors are drawn to the funds to get in on hedge-fund-like strategies such as short selling, which involves selling borrowed shares in order to profit from an expected price decline. Many quant funds short stocks because the computer can rank every stock in the fund's universe every day, and the fund can buy the highest-ranked stocks and short the lowest-ranked names. A traditional fund manager typically must do extra research to determine which stocks to short. The new hedge-like mutual funds Rydex Hedged Equity and American Century Long-Short Equity are run using quantitative models.

    But because quant funds closely guard the details of their investing strategies, it can be difficult for investors to judge how much risk they are taking on. "If you share too much, the world will copy you," says Jeff Mortimer, chief investment officer for equities at Schwab's fund-management unit.

    The funds also can rack up higher transaction costs than traditional funds, since quant funds typically buy and sell stocks whenever their computer models tell them to. This can eat into a fund's total return. For investors, it also can lead to short-term capital gains and higher tax bills. Numeric Investors LLC, which runs four quantitative funds, cautions investors in its prospectus that the funds are "better suited for tax-deferred type accounts because of the potential for taxable capital gains."

    Studies have found that quantitative funds have performed slightly better than traditional actively managed funds over the past few years, but over the longer term have delivered returns quite similar to market indexes. In a study of large-cap funds designed for big investors like pension funds, consulting firm Casey, Quirk & Associates found that quantitative funds returned 5.6% annually in the three years ending 2004, versus 4.5% for traditional funds. Another recent study found that quant funds generally have lower expense ratios than traditional actively managed funds, but higher expense ratios than funds that track market indexes.

    Quant funds have performed well in recent years partly because of their tilt toward value stocks, which are seen as undervalued based on their earnings or assets. Now, many money managers believe value stocks have run their course and investors will soon shift to growth stocks, whose earnings tend to grow faster than the market average, and this could hurt many quant funds. "I worry that people are just buying performance," says Joel Dickson, head of the active quantitative equity group at Vanguard Group.

    For now, investors seem to be flocking to quant funds. Enhanced Investment Technologies LLC, which manages quant funds for Janus and other fund companies under the INTECH name, saw its assets under management increase 73% last year, to $45 billion. Assets in Schwab's quantitative funds roughly doubled last year to $9.5 billion. And quant firm Analytic Investors Inc. also saw assets in its funds double in the past year, to $11 billion.

    But some investors who hold quantitative funds may not be aware that a computer is managing their money because many of the funds' names don't include the word quantitative. Some companies play down the fact, because the complex strategies aren't easily explained in marketing materials, industry experts say.

    While quant managers often say the strategy removes emotion from the investing process, a number of managers add some discretion of their own. For most of last year, for example, Schwab's quantitative fund managers didn't follow their computer's suggestion to buy more shares of drug-maker Merck & Co. because of worries about the company's drug Vioxx, which was recalled in 2004, says Mr. Mortimer, the investment officer. The stock has generally been a poor performer but is up 13% this year.

    Other managers give the computer the benefit of the doubt. When a computer model told John Montgomery, founder of quantitative firm Bridgeway Funds, to buy Research In Motion Ltd., he was concerned that the maker of the BlackBerry was a one-product company and that rivals were gaining ground. Mr. Montgomery says he bought the stock anyway in 2004 and made money on it.

    Fund companies are seeking to capitalize on quant funds' recent strong performance with new offerings. Allegiant Asset Management Co. now has four quantitative funds after launching three computer-driven offerings late last year and converting an existing fund, Allegiant Multi-Factor Small Cap Value, to a quant strategy. American Century Investments, which manages seven quantitative funds, is launching three more. The company's core, large-cap quant fund, American Century Equity Growth, has returned 7% a year in the past five years with an expense ratio of 0.67%.

    Vanguard, which mainly runs low-cost, index funds, recently entrusted part of the management responsibility of its Vanguard Energy fund and Vanguard Equity Income fund to its in-house quantitative equity group. The company plans to launch a new small cap quant fund. Another quant fund, Vanguard Strategic Equity, has returned 15.5% a year in the past five years with an expense ratio of 0.4%.

    Some quant strategies are complex. Analytic Investors looks at more than 70 different stock characteristics and adjusts the relative weighting of those characteristics monthly as their importance to investors changes. A few years ago, investors were focused on stocks' dividend yield, but now they're more interested in earnings growth, says Harindra de Silva, Analytic's president. He says the company has changed the weightings in its computer models to adapt to the new preference. (See related article.)

    Some quant funds disclose their stock-picking criteria but keep other elements of their strategy secret. The quantitative Hennessy Cornerstone Growth fund, for example, relies on four main criteria to drive investment decisions, one of which is price momentum -- essentially, a rising stock price, says portfolio manager Neil Hennessy. But partly to keep trading costs low, the fund updates its portfolio only once a year, and it won't reveal which date that is.
  2. its all about the fees.