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Quant funds win with math
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October 25, 1999: 9:03 a.m. ET
Using sophisticated models, these funds screen for the best stocks
By Staff Writer Martine Costello
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NEW YORK (CNNfn) - Price-to-book. Earnings revisions. Revenue growth. EBITDA. Just a few of the hundreds of variables a money manager has to consider when he's picking stocks.
Thanks to technology, some fund managers are turning to computers to sift through the mountain of data piled up on Wall Street.
"It's harnessing the power of computers," said Steven Esielonis, manager of the Quantitative Growth & Income Fund. "We can ferret out the companies with certain characteristics that we think will do well …It takes the emotion out of stock picking."
The Quantitative Growth & Income Fund, with $69 million in assets, is up 2.1 percent as of Sept. 30, according to fund-tracker Morningstar. The fund is rated four out of five stars for risk-adjusted returns, and it ranked in the top of its category in 1998 and 1997.
Quant investing, where managers use advanced mathematical models to screen for stocks, is far from mainstream. Chicago fund researcher Morningstar follows roughly 30 quant funds, but does not track the category separately.
Yet quant fund managers say the strategy is getting more attention, and more fund companies are introducing products.
Don D'Onofrio, head of Merrill Lynch Quantitative Advisors, said strategies that were once used exclusively by institutional investors like pension funds are trickling in to the retail mutual fund industry.
"The mutual fund industry has exploded," D'Onofrio said. "What we're doing is bringing these techniques and packaging them so the average Merrill Lynch customer can play the same game as a person in AT&T's pension fund."
Merrill Lynch formed the quant unit in July and plans to introduce six quantitative funds in January. The Securities and Exchange Commission is reviewing them.
"There's less emotion and more deliberate calculations," D'Onofrio said.
How it works
Every quant manager has his or her own formula for screening stocks. Some may use price-to-book, or the difference between the market value of a stock and the book value of the company; or EBITDA, or earnings before interest, taxes, depreciation and amortization, a measure of cash flow.
Many quant funds also pay close attention to changes in earnings estimates, said Esielonis, of Quantitative Growth & Income Fund.
Esielonis said his models whittle down a universe of 6,000 stocks to about 1,200 names, then rank them on value and growth components.
Then Esielonis looks to build a portfolio with similar industry weightings as the S&P 500. For example, he'll try to stick to 23 to 24 percent in technology, like the S&P 500.
"Models are good at sifting through mountains and mountains of data," Esielonis said.
One of best names in quantitative investing is Chuck Albers, manager of Oppenheimer Main Street Growth & Income Fund, said Christine Benz, an analyst at Morningstar. While most quant funds are "bottoms-up" investors, Albers is a "top-down" investor as well. Albers also uses much more complex models to screen stocks, she said.
"He has one of the longest records, he's more a pure quant investor," Benz said. "He's got a phenomenal record."
The Oppenheimer Main Street Growth & Income Fund, with $7.5 billion in assets, is up 4.8 percent as of Sept. 30, Morningstar said. It has a coveted five-star ranking at Morningstar, putting it in the top 10 percent of its category. (Efforts to reach Albers for comment were unsuccessful).
More than a numbers game
But managers say it's not just a question of flipping on a computer. Screening the stocks is just the first step. A manager has to build the portfolio by taking into account factors that a computer can't measure, like investor sentiment and inflation fears.
"This is where the non-quantitative part of a portfolio manager's job comes in," Esielonis said. So if technology is on a great run, he may overweight it in his fund.
Shannon Vanderhooft, portfolio manager at Numeric Investors, said the models might rate bank stocks highly without considering that Wall Street may be punishing them because of rising interest rates.
Numeric Investors offers five quant funds, ranging from a micro-cap growth fund to a large-cap value fund.
Vanderhooft said it's important for managers to make sure the data they are using in the models is accurate -- and to revise the models as conditions on Wall Street change.
"They're not huge, sweeping changes," Vanderhooft said. "They're finesse changes."
Likewise, Benz said a quant fund model may pick up a lot of tobacco stocks without taking into account the flood of litigation hitting the cigarette makers.
Better for volatile times?
Vanderhooft said quant funds may be good during stock market volatility because they are more disciplined and less likely to be swayed by emotion.
At the same time, quant funds look at a broad spectrum of stocks. So in a market where a few names are leading the way, quant funds may have a harder time. The Numeric funds, for example, have had a rocky year, Vanderhooft said. The small cap strategies are holding their own against benchmarks, but the large value fund has lagged along with the rest of value stocks, she said.
"It's been a strange market, concentrated in a very small number of names," Vanderhooft said.
Another advantage is the fees should be lower since quant funds don't require heavy research, Benz said.
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