Quant funds tested by tough market

The proliferation of mutual funds that rely on computers to select stocks is coming to an end. Mutual fund companies had rolled out 29 so-called quantitative funds year-to-date through Aug. 31, down nearly 58% from 69 the comparable period a year earlier. In 2007, a record 117 quant funds made their debut, according to Lipper Inc. of New York. Assets in such funds, meanwhile, totaled $72.9 billion July 31, down from $76.4 billion at the beginning of the year, Lipper noted. A quant fund is a mutual fund — or in some cases a hedge fund — that relies on complex and sophisticated mathematical algorithms to pick stocks. Quant funds, which essentially remove emotion and instinct from the investment process, emerged in the 1970s and became popular in the 1990s as computers became more powerful. The problem with many quant funds is that they become less reliable in volatile markets. That's because such funds tend to rely on historical data. Any significant deviation from a historical norm requires the human managers to update the fund's strategies and assumptions — a process that takes time.

MISSING THE MARK

In the current market environment, many quant funds have fumbled. Consider, for example, Janus Advisers Intech Risk-Managed Growth Fund (JDRAX). The $1.33 billion fund is managed by Palm Beach Gardens, Fla.-based Enhanced Investment Technologies LLC, a quant manager owned by Janus Capital Group Inc. of Denver. Year-to-date through last Wednesday, the fund had fallen 14.7%, versus -11.51% for its benchmark, the Russell 1000 Growth Index. The fund declined 9.63% over the one-year period, versus an 8.58% drop for the index. "You've seen many quantitative managers struggle in performance and flows," Janus chief executive Gary Black said during a conference call in July to discusses the company's second-quarter earnings. Net inflows into Intech totaled $200 million during the second quarter, an improvement from outflows of $1.1 billion the previous quarter. Then there is Bridgeway Aggressive Investors 2 Fund (BRAIX), from Bridgeway Capital Management Inc. of Houston. The $792 million fund had declined 20.2% year-to-date and 11.5% over the one-year period. Its benchmark, the Standard & Poor's 500 stock index, had dropped 11.89% year-to-date and 11.64% over the one-year period. Another well-known quant fund, the $168 million Bogle Small Cap Growth Fund (BOGLX), had plunged 15.07% year-to-date and 19.49% over the one-year period. The fund's benchmark, the Russell 2000 Index, meanwhile, had dropped 2.29% and 5.17% over the year-to-date and one-year periods, respectively. Bogle Small Cap Growth is managed by John C. Bogle Jr., president of Bogle Investment Management LP of Newton, Mass., and son of John C. Bogle, founder of The Vanguard Group Inc. of Malvern, Pa. The downturn in performance explains why fund companies aren't rushing to bring out new quant funds, said Reuben Gregg Brewer, director of research at Value Line Inc. of New York. "People don't want to bring out products that aren't going to do well," he said.

MORE TROUBLE AHEAD?

Unfortunately for quant managers, the market environment is likely to persist for some time, said Brian Goodstate, a portfolio manager with Paragon Capital Management, a Denver-based firm with about $600 million under management that has developed in-house quantitative strategies. "I don't know if we have gotten past the market volatility that has felled many quant funds," he said. "I'm guessing we haven't." Some quant funds are performing relatively well. The $797 million Vanguard U.S. Value Fund (VUVLX), which is subadvised by both Vanguard's Quantitative Equity Group and Axa Rosenberg Investment Management LLC of Orinda, Calif., had dropped 9.74% year-to-date through last Wednesday, and was down 12.14% for the one-year period. Its benchmark, the Russell 3000 Value Index, dropped 10.87% year-to-date and was down 13.64% for the one-year period. Such distinctions, however, are lost on the investing public. "The fact that quant strategies of different stripes are lumped together doesn't help," Benjamin Poor, a director with Cerulli Associates Inc. of Boston, wrote via e-mail. Financial advisers, for their part, have mixed feelings about quant funds. "When there is little direction, when trends are short, quants seem to have a hard time keeping up with rapid changes in market direction," said Robert Bolen, a principal with Bolen Dodson & Associates, a Brentwood, Tenn.-based advisory firm with about $60 million under management. That doesn't mean, however, that there isn't a place for such funds in a client's portfolio, he said. For example, Mr. Bolen includes two quant funds — the $55 million Empiric Core Equity Fund (EMCAX), from Empiric Advisors Inc. of Austin, Texas, and the $386 million Arrow DWA Balanced Fund (DWAFX), from Arrow Investment Advisors LLC of Olney, Md., in some client portfolios, he said. "Most quant funds have something of a trend-following attribute," Mr. Bolen said. "Long-term, I believe that when trends develop, they persist." Don Martin, president of May-flower Capital in Los Altos, Calif., isn't so sure. "I think it's too easy to fool oneself with a quant formula," said Mr. Martin, who declined to give his firm's assets under management. E-mail David Hoffman at dhoffman@investmentnews.com.