Your Questions Answered: I want to diversify my portfolio. Please elaborate on quant mutual funds

Q. I am a Senior Creative Director working with a marketing agency in Bengaluru. I have been investing in large-cap index mutual funds for the past 4 years. I plan to diversify my portfolio and invest in other categories. Many of my acquaintances have suggested that I invest in quant funds. However, I am not familiar with how quant funds work. Can you please elaborate on the functioning of quant funds, additionally, please elaborate on the pros and cons of investing in quant funds.

T Nagraj, Ulsoor, Bengaluru, Karnataka

Introduction

At the very beginning, we wish to clarify that the category of funds known as quant mutual funds should not be confused with the Indian mutual fund house named ‘Quant Mutual Fund’. In the world of investing, quant funds have emerged as a sophisticated and data-driven approach to managing portfolios. These funds leverage advanced mathematical models, algorithms, and quantitative analysis to make investment decisions. Let’s dive into what quant funds are, how they work, and why they might be a valuable addition to your investment strategy.

What is a quant fund?

Quant funds, short for quantitative mutual funds, use compute/algorithm-based models to select securities and manage portfolios. Unlike traditional mutual funds, which rely on the expertise and judgment of fund managers, quant funds depend on data and algorithms to drive their investment decisions. These models analyse vast amounts of historical and real-time data to identify market patterns, trends, and opportunities.

The mechanics of quant funds

1. Data collection: The foundation of quant mutual funds lies in the vast amounts of data they collect. This data can come from various sources, including financial statements, market prices, economic indicators, and even alternative data like social media sentiment and news articles. The goal is to gather as much relevant information as possible to feed into the quantitative models.
2. Model development: Quantitative analysts, often referred to as quants, develop complex mathematical models to process and analyze the collected data. These models are designed to identify patterns, trends, and correlations that can indicate profitable investment opportunities. The models can range from simple statistical analyses to advanced machine-learning algorithms.
3. Backtesting: Before deploying a model in the real market, it undergoes rigorous backtesting. This involves running the model on historical data to evaluate its performance and make necessary adjustments. Backtesting helps ensure that the model is robust and capable of delivering consistent results under different market conditions.
4. Execution: Once a model is validated, it is used to make investment decisions. The model generates buy and sell signals based on the data it processes, and these signals are executed automatically by the fund’s trading systems. This automation allows for quick and efficient execution of trades, minimising the impact of human emotions and biases.
5. Continuous monitoring and improvement: Quant models are continuously monitored and updated to adapt to changing market conditions. This ensures that the fund remains effective and responsive to new information. Quants regularly review the performance of the models and make adjustments as needed to optimise returns and manage risk.

Advantages of investing in a quant fund

Let’s explore the numerous advantages of investing in quant mutual funds and why they might be valuable to your investment strategy.

1. Objectivity and discipline: One of the most significant advantages of quant mutual funds is their objectivity. Unlike traditional mutual funds, which rely on the expertise and judgment of fund managers, quant funds depend on data and algorithms to drive their investment decisions. This eliminates human biases and emotions from the investment process, leading to more disciplined and consistent investing.

2. Consistency in strategy: Quant models follow predefined rules and strategies, ensuring a consistent approach to investing. This can be particularly beneficial in volatile markets where emotions can lead to irrational decisions. By adhering to a systematic and data-driven strategy, quant funds can maintain a steady course even during turbulent times.

3. Efficiency in data processing: Quant funds can process and analyze vast amounts of data much faster than human analysts. This allows them to identify opportunities and execute trades more efficiently. The ability to quickly analyze large datasets and react to market changes can provide a competitive edge in the fast-paced world of finance.

4. Diversification: Quant models can analyze a wide range of securities and asset classes, enabling the fund to diversify its portfolio effectively. Diversification helps reduce risk by spreading investments across different assets, sectors, and geographies. This can enhance returns and provide a more stable investment experience.

5. Advanced risk management: Quant funds use sophisticated risk management techniques to monitor and control exposure to various risks. These techniques include stress testing, scenario analysis, and real-time risk monitoring. By actively managing risk, quant funds can protect the portfolio from significant losses during market downturns.

6. Potential for outperformance: Quant funds have the potential to outperform traditional investment strategies, especially in complex and dynamic markets. By leveraging advanced algorithms and data analysis, quant funds can identify unique investment opportunities that may be overlooked by traditional approaches. This can lead to superior returns over the long term.

7. Adaptability to market conditions: Quant models are continuously monitored and updated to adapt to changing market conditions. This ensures that the fund remains effective and responsive to new information. The ability to adapt quickly to market changes can help quant funds stay ahead of the curve and capitalize on emerging trends.

8. Transparency and accountability: Quant funds operate based on transparent and well-documented models. Investors can understand the underlying strategies and the rationale behind investment decisions. This transparency fosters trust and accountability, providing investors with confidence in the fund’s approach

Cons of investing in quant funds

While quant funds offer numerous advantages, such as objectivity, consistency, and advanced risk management, they also come with certain drawbacks. It’s essential to understand these potential cons before deciding to invest in a quant mutual fund. Let’s explore some of the key disadvantages of quant mutual funds.

1. Complexity: Quant mutual funds rely on complex mathematical models and algorithms to make investment decisions. These models can be difficult for the average investor to understand. The complexity of these strategies may lead to a lack of transparency, making it challenging for investors to fully grasp how their money is being managed.

2. Model risk: Quantitative models are based on historical data and certain assumptions about market behavior. There is always a risk that these models may not perform as expected, especially in unprecedented market conditions. If the assumptions underlying the models prove to be incorrect, it can lead to significant losses. Over-reliance on models can be a double-edged sword, as they may fail to account for unforeseen events or market anomalies.

3. Limited human judgment: While the elimination of human biases is one of the strengths of quant mutual funds, it can also be a drawback. Quant models operate purely based on data and algorithms, without the ability to incorporate qualitative factors or human intuition. In certain situations, human judgment and experience can provide valuable insights that models may overlook.

4. Data dependency: Quant models rely heavily on the quality and accuracy of the data they process. Inaccurate or incomplete data can lead to flawed investment decisions. Additionally, quant funds may face challenges in obtaining and processing alternative data sources, which can impact the effectiveness of their models.

5. Market saturation: As more investors and funds adopt quantitative strategies, the market may become saturated with similar models and algorithms. This can lead to increased competition and reduced effectiveness of certain strategies. When too many funds are using similar models, it can result in crowded trades and diminished returns.

Who should invest in quant funds?

Quant funds are suitable for a variety of investors. We have mentioned below a few categories of investors who can benefit from investing in Quant Funds.

1. Long-term investors: Quant mutual funds are designed to deliver consistent returns over the long term. If you have a long-term investment horizon and are willing to stay invested through market cycles, quant funds can help you achieve your financial goals. The disciplined and systematic approach of quant funds can provide stability and growth over time.

2. Risk-averse investors: Quant mutual funds use sophisticated risk management techniques to monitor and control exposure to various risks. If you are a risk-averse investor looking for a well-diversified portfolio with advanced risk management, quant funds can offer a balanced approach to investing. These funds aim to minimize losses during market downturns while capturing gains during upswings.

3. Investors seeking diversification: Quant mutual funds can analyze a wide range of securities and asset classes, enabling effective diversification. If you want to diversify your investment portfolio across different assets, sectors, and geographies, quant funds can help you achieve this goal. Diversification can reduce risk and enhance returns, providing a more stable investment experience.

4. Investors looking for consistency: Quant models follow predefined rules and strategies, ensuring a consistent approach to investing. If you value consistency and discipline in your investment strategy, quant mutual funds can provide a systematic and objective approach to managing your portfolio. This can be particularly beneficial in volatile markets where emotions can lead to irrational decisions.

5. Investors with a high tolerance for complexity: Quant funds rely on complex mathematical models and algorithms, which can be difficult for the average investor to understand. If you have a high tolerance for complexity and are willing to trust the expertise of quantitative analysts, quant funds can be a suitable investment option. It’s essential to be comfortable with the intricacies of quantitative strategies and the potential risks involved.

Performance and returns

Several mutual funds in India offer quant funds. Below we have listed the 5 quant funds along with their 3-year returns (CAGR).

Source: AMFI website; as of 10 January 2024.

Note: Past returns are not indicative of future returns.

Taxation of quant fund

It is important to understand that quant funds in India are typically a sub-category of equity mutual funds. They are therefore taxed as equity mutual funds. Below we have mentioned in detail how equity mutual funds are taxed.

Key changes in mutual fund taxation post-budget 2024

1. Short-Term Capital Gains (STCG): The Budget 2024 increased the short-term capital gains tax on equity mutual funds from 15% to 20%. This change applies to gains from selling equity mutual fund units held for less than 12 months. For debt mutual funds, short-term capital gains are taxed at the investor’s income tax slab rate.
2. Long-Term Capital Gains (LTCG): The long-term capital gains tax on equity mutual funds was raised from 10% to 12.5%. This applies to gains from selling equity mutual fund units held for more than 12 months. For debt mutual funds, long-term capital gains are also taxed at 12.5%, with the indexation benefit removed.
3. Holding periods: The Budget 2024 rationalised the holding periods for short-term and long-term capital gains. For equity mutual funds, the holding period for long-term capital gains is 12 months, while for debt mutual funds, it is 24 months.
4. Tax-free threshold: The tax-free threshold for long-term capital gains on equity mutual funds was increased from ₹1 lakh to ₹1.25 lakh per financial year. This means that gains up to ₹1.25 lakh in a financial year are exempt from tax.

Implications for investors in quant funds

1. Higher tax rates: The increase in short-term and long-term capital gains tax rates means that investors in quant mutual funds will face higher tax liabilities on their gains. This is particularly relevant for investors who frequently trade in and out of mutual fund units.
2. Strategic holding periods: Investors may need to adjust their investment strategies to optimise their tax liabilities. Holding equity mutual fund units for more than 12 months can help investors benefit from the lower long-term capital gains tax rate and the increased tax-free threshold.

Conclusion

Quant funds represent a cutting-edge approach to investing, leveraging data and technology to make informed and objective decisions. While they offer numerous benefits, including objectivity, consistency, efficiency, diversification, and risk management, they also come with potential drawbacks such as complexity, model risk, and higher costs. As with any investment, it’s essential to conduct thorough research and consider your individual financial goals and risk tolerance before investing in quant funds.

Disclaimer: Investing in mutual funds involves risks, including potential loss of principal. Please consult with a financial advisor before making any investment decisions.

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