Quantitative strategies, also known as "quant" strategies, have become increasingly popular in recent years as a way to improve portfolio performance and manage risk.
Presently, discretionary active funds dominate investors’ equity portfolio by a wide margin compared to other instruments. They have been the obvious choice for investors looking to beat the market. However, under the radar, the demand for quantitative strategies has been slowly brewing. The increased interest in quant strategies may be attributed to the crux of what it offers i.e., ability to measure expected outcomes better.
These strategies use mathematical models and statistical analysis to make investment decisions. This contrasts with the traditional approach of extrapolating fundamental data into the future, based on forward estimates and projections – a technique commonly followed in discretionary fund management. One of the main advantages of quantitative strategies is that they can help to reduce the impact of emotions on one’s investment decisions.
But how does one make use of these strategies in their portfolio? The most straightforward answer to this is to start with a satellite allocation (20%-30%) to the core discretionarily managed equity portfolio. The investor gains diversification benefits not only in terms of exposure to a different strategy but also to the fact that some part of the portfolio is now managed in a non-discretionary manner. This is simply extending the principles of diversification beyond asset classes to the nature of investing as well.
The second question to ask is, how to decide which quantitative strategies should one invest in. A useful way to think about this is to add an allocation that will make the portfolio better risk-diversified.
For example, currently, most investors are heavily allocated to the market risk factor. 55% of the risk in the average mutual fund investor portfolio comes from their exposure to the market – which also implies that their portfolio performance would be fairly similar to the broader market movement.
However, academic research has uncovered other unique sources of risks, (factors like Momentum, Quality and Value), which are less correlated to market risk and offer additional diversification benefits. This could be a great starting point for investors looking to allocate to quantitative portfolios – look for allocations that offer different sources of risk than market risk .
Investors can allocate to quantitative strategies tactically or strategically.
Strategic allocation starts by identifying exposures that are independently positive return generating, and at the same time less correlated with the remainder of the portfolio. The allocation to these exposures depends on the risk tolerance of individual investors, and is largely static over time, unless the risk tolerance materially changes.
For example, an investor who wishes to experience slightly better downside performance compared to an equity benchmark, without compromising on the upside participation could combine factors like momentum and low volatility, which have traditionally delivered 5.5% outperformance over the entire cycle, while capturing only 50% of market downside but 115% of market upside.
Tactical allocation offers investors the ability to time exposures that have demonstrated a historical ability to outperform in a given market condition. Such a strategy allows investors to express their market views in a cost efficient manner.
Though quantitative strategies are not just limited to factors, they can be an ideal starting point for many investors looking to add such exposure. Below is a table that summarizes popular factor characteristics and may help an investor make an informed decision.
Performance of popular factors during market cycles and which type of investor it is suitable for:
| Risk Factor | Investor seeking | Outperforms During |
| Momentum | High returns with high churn | Bull |
| Low Volatility | Volatility reduction | Bear |
| Quality | Established and proven businesses | Bear |
| Value | Turnarounds | Recovery |
Disclaimer/Source: MOAMC Research. The above graph is used to explain the concept and is for illustration only and should not be used for developing or implementing an investment strategy. Past performance may or may not be sustained in future.
Incorporating quantitative strategies into a portfolio can provide several benefits, including increased diversification and risk management, and the ability to make data-driven investment decisions. However, it's important to keep in mind that quantitative strategies are not without their limitations.
For example, these strategies can be affected by changes in market conditions or by errors in the data used to inform the models. Additionally, quantitative strategies can be complex and difficult to understand, which can make them less accessible to the average investor. A combination of quantitative strategies along with discretionary investment strategies, might be a better recipe for a well-rounded portfolio.
Sankaranarayanan Krishnan is the Quant Fund Manager for PMS and AIF schemes at Motilal Oswal Asset Management Company Ltd.
