Warning: getimagesize(): Filename cannot be empty in /home/blackenterprise/public_html/wp-content/themes/blackenterprise/single-standard.php on line 35
Mutual fund managers move billions of dollars of investors’ money each year. They’re a highly educated group, backed by skilled researchers and state-of-the-art software. Yet, according to mutual fund tracker Morningstar, only 37.27% of them get results that are better than average — that’s the portion of diversified stock funds that have outperformed the benchmark Standard & Poor’s 500 Index for the last 10 years (through August 2005).
Why do so many fund managers miss the mark? One explanation is that they, like all investors, are prone to emotional mistakes. They buy on whims and hold on to poor choices too long. So if you’d like your funds managed by facts rather than feelings, you do have an option: Invest in quant funds. “Quant funds select their portfolios solely on quantitative measures,” says Kai Wiecking, a mutual fund analyst at Morningstar. “A lot of research indicates that investors’ behavior can lead to errors. Taking the emotion out of investing may reduce some of those errors.”
But isn’t there number crunching involved with all mutual funds? “Many actively managed funds use simple screens to come up with a pool of potential investments. Then they’ll look more closely into those limited names.” says Vivienne Hsu, vice president and senior portfolio manager for Charles Schwab Investment Management in San Francisco. “On the other hand, the power of quantitative investing allows me to evaluate thousands of stocks at a time using Schwab’s research.”
A variety of criteria are weighed in making up the portfolio of a quant fund. Schwab has developed a proprietary model used to build many of these funds. Vanguard, Bridgeway, and American Century also offer quant-styled funds. The Schwab model weighs 18 different criteria divided among four categories:
Fundamental statistics. A company’s positive balance sheet and income statement, for example.
Valuation. “Instead of the standard price-to-earnings ratio, we’re more concerned about the ratio of a stock’s price to cash flow from operations,” says Hsu. The lower the price-to-cash flow ratio, the more likely the firm is undervalued.
Momentum. Are savvy investors buying or selling? Schwab downgrades stocks that are under pressure from short sellers and insiders.
Risk factors. According to Hsu, large, established companies tend to be more stable and thus less risky for investors.
Schwab applies its stock selection model to 3,000 stocks and comes up with numerical ratings that are ranked in five groups. The top 5% are considered A-rated, the next 25% are B-rated, the middle 40% are C-rated, the next 25% are D-rated, and the bottom 5% receive F ratings. Schwab selects funds from only the highly rated stocks. The top 30 make up group 1; the next 30, group 2, and so on. In building quant fund portfolios, stocks in the highest-rated groups are chosen first. This is how the stocks are selected by the numbers. “The most successful quant funds don’t tell you much about their models, so it’s a leap of faith for investors,” says Wiecking. Macro data may be studied in making up a quant fund, too. For example, if a