Kotak Mahindra AMC has entered the quant funds arena with the launch of ‘Kotak Quant Fund’, whose new fund offer closes on July 26. The primary objective of quant funds is to generate long-term capital appreciation by investing predominantly in equity and equity-related securities that are selected on the basis of a quant model theme.

Already, there are half a dozen funds in this space, managing about Rs 2,500-plus crore. Will Kotak Quant Fund be able to build a strong case for such funds, which have so far not been able to build a compelling return record? Let us find out.

Decoding quant investing

Quant funds follow a factor-based approach, compiled through quantitative analysis, for choosing securities. Kotak Quant Fund will construct a portfolio (35-50 stocks) selected on the basis of an in-house proprietary quantitative model. It will invest a minimum of 80 per cent of net assets in equity and equity-related securities selected on the basis of the quant model theme, as per mandate.

Kotak’s quant model does not take cash calls, does not choose new stocks between two rebalances, and makes no attempt to classify on the basis of sectoral and market cap movements.

The investment process of Kotak Quant will be based on a factor-based approach with the aim of generating superior risk-adjusted returns compared to the benchmark. Do note that one-year Sharpe ratios of existing quant funds are not very different from those of large- and midcap funds.

The stocks for the fund will be chosen from a universe of NIFTY 200 TRI selected on the basis of quantitative measures like data availability, liquidity, and so on. Other factors would be used to evaluate the stocks’ attractiveness from a risk and return perspective. For instance, the model will look at various factors to determine growth outlook while considering valuation parameters for every company.

Like many funds, Kotak Quant Fund will apply objective pre-defined criteria that excludes companies that are either very illiquid or score poorly on governance standards, excessive leverage, or past drawdown behaviour, or capital allocation, or return metrics, or on consistent operating parameters.

Flexibilities

The fund manager of Kotak Quant Fund may change the above quantitative and qualitative parameters by the addition or deletion of parameters to optimise the model. The weights are primarily optimised around prudent diversification, with inputs from volatility observed, consideration of portfolio churn, and so on.

The fund manager can override the quant model in case of impact cost, liquidity management, and corporate action to sell a stock. However, the fund aims to keep the portfolio aligned to the quant model in most cases.

The portfolio of the scheme will be reviewed regularly and rebalanced by the fund manager, based on the output of the model. The fund manager will also review and maintain the model (including variables) on an ongoing basis and make changes as needed.

The approach is to use the quant model as a guide; the fund manager may also use other parameters such as economic parameters, investment indicators, and so on.

The fund may look to invest overseas for diversification of markets and currency. This can help the scheme in achieving higher returns, especially in markets that are experiencing strong economic growth or have undervalued assets. However, given the theme of the fund, such exposure will be limited to a maximum of 20 per cent of net assets.

Important to note that the scheme may also invest in equity and equity-related instruments that are not part of the in-house proprietary quantitative model.

Flipside of quant funds

So far, the investor experience in terms of returns from quant funds has been mixed.

Quant funds usually have higher turnover than other diversified equity fund. If Kotak Quant Fund is able to generate decent returns without churning portfolio turnover, too, it will generate a differentiated experience.

Returns from quant funds have not been markedly different when compared to other equity funds. Quant funds use BSE 200 as a benchmark, which is a fair mix of large- and midcaps. See the returns of existing quant funds in the table below.

You will notice that every second quant fund has underperformed BSE 200 in one-year basis, and two out of three quant funds lagged BSE 200 in three-year basis. So, from a return perspective, as a category they have not provided great value for all the ‘quant’ factors used. Hence, Kotak Quant Fund has a good opportunity to build a great return experience and prove that quant-based investing not only removes human bias but can also deliver superlative returns.

Investors should also note that quant funds do not provide any great downside protection, especially during sharp downturns. For instance, three quant funds with three-year NAV history have 85-102 per cent downside capture ratios, which do not indicate any great extra layer of protection when markets tumble. At the same time, their upside capture ratios of 73-95 per cent indicate they do not get the full upswing when markets rise. When you look at the one-year upside/downside capture ratios, only 360 One Quant Fund stands out but it has a very short period of existence.

While the fund’s presentation gives details on the back-tested data of Kotak Quant Model, we disregard the same, given it is fully theoretical in nature. While Kotak Quant Fund shall endeavour to follow the theoretical quant model, there may be deviations when it actually goes live.

Our take

For all the combined man-machine virtues extolled by quant fund models over the years, crunching the numbers does not show any extra returns posted by quant funds compared to other actively-managed equity funds.

Hence, there is good scope for a new quant fund such as this Kotak offering to walk the talk and make a strong case if it is able to deliver on the return front. So, wait for the track record.

Published on July 20, 2023