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Public Quant Funds Aren't Always What They Seem

There's a distinction between funds that select small-cap stocks and those that take size into account.

By Aaron Brown

(Bloomberg Prophets) --Quantitative equity strategies  are a fast-growing retail product. There is more than $150 billion in quant equity public mutual funds, and such ETFs are on track to top $1 trillion this year.

Unfortunately, there’s little agreement on what these funds are. The two most common definitions are “uses numbers to select stocks” and “follows a systematic selection process.” Neither is useful because almost all professional investors use numbers and have a process.

A better definition is, “picks stocks based on designated factors.” This highlights that quants regard a stock as a bundle of factor exposures. But it misses another point. Traditional investors use factors such as price-to-earnings ratios and earnings growth to select good stocks, while quant equity investors select stocks to get specified exposure to factors such as value and quality. To a traditional investor, anything can be a factor, and an input to the stock selection process. To a quant, there are only a few reliably documented factors,  and they are the outputs of the portfolio construction process.

For example, one of the oldest quant factors is size.  Small-capitalization stocks have consistently delivered better risk-adjusted returns than large-capitalization stocks. An investor could take advantage of this observation by buying a Russell 2000 index fund (a passive fund that buys only small capitalization stocks), an actively managed small-cap stock fund -- or an equally weighted S&P500 index fund or a smart beta size ETF. The latter two are normally considered quant portfolios.

No one has a trademark on “quant equity” and fund marketers can use the term however they like. But investors should appreciate the distinction between funds that select small-cap stocks and those that deliver exposure to the size factor.

The first three types of fund above, and most of the funds labeled “smart beta,” select small-cap stocks and should be benchmarked and managed the same way as traditional funds. They deliver a mix of factor exposures. Small-cap stocks usually have higher P/E ratios, faster growth, more volatility and beta, less debt and lower dividend yields than large-cap stocks. They are far more likely to have negative earnings; and they are concentrated in certain industries.

A true quant equity-size portfolio uses a composite measure to determine size, and constructs portfolios with the same P/E ratio, growth, industry distribution and other parameters as the overall market.  That’s why you need a computer and researchers for quant equity; anyone can select small-cap stocks by hand.

Investing in a true quant equity portfolio is like investing in an asset class. You invest in stocks because theory and long-term evidence suggests that you earn a risk premium for doing so. Theory and long-term evidence also suggest you earn risk premiums by investing in factors such as size, momentum, value and quality.

In all cases, it is foolish to change allocations based on performance. It’s also foolish to think quant equity funds will do well or badly as a group.  There will be periods (often multiyear periods) where some factors underperform or outperform, but investment in factor portfolios should be based on long-term faith rather than recent results.

Finally, you should think of fees differently from traditional active investment. Quant equity returns are beta returns,  returns from exposure to risk factors. Fees are higher than index funds not because the manager has any unique insight (alpha) but because the process has higher costs and turnover. Traditional active managers promise alpha. If you believe them, you should think of fees as payment for alpha, not as compensation for the expenses of running their process.

Quant equity offers investors attractive ways to harvest risk premiums at reasonable cost. But if you manage it like traditional active management -- benchmarking against the market, paying alpha fees for outperformance and dropping managers for underperformance -- you will not only miss the advantages, but likely underperform the market. You should also avoid the opposite mistake, paying more than index fund fees for funds labeled “quant equity” or related terms, that merely apply quantitative criteria to selecting stocks, without delivering calibrated exposure to recognized compensated factors.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street."

To contact the author of this story: Aaron Brown at [email protected] contact the editor responsible for this story: Max Berley at [email protected]

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