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Bruised Quant Funds Seek A Human Touch

Computer-driven mutual funds, chastened by a string of poor results and a wave of redemptions, are striving to bring more of a human touch to their investment decisions. These so-called quantitative funds, which rely largely on computer models to select investments, have been on the fritz for several years. A group of 65 such funds tracked by investment-research firm Morningstar Inc. lagged behind 72% of their category rivals, on average, in the three years ended Aug. 27. And the quants’ woes aren’t just about performance. In mid-April, AXA Rosenberg Group LLC told clients that a “coding error” had affected its computer-driven investment process. Though the error was discovered and corrected in 2009, the company said, high-level investment personnel had kept the problem under wraps. Mutual-fund companies and other investors frustrated with the communication breakdown yanked billions of dollars from the firm. Now, quants are seeking to win back investors not just with their characteristic number crunching but also with a bit of soul searching. Many of the funds’ managers are seeking to make their models a little more like people, by making them more responsive to changing circumstances. That can mean revisiting computer models more often, tweaking their components, or incorporating measures of macroeconomic risk rather than just stock-specific information. Quant managers need to understand “that financial markets are better understood through the lenses of a biologist rather than a physicist,” says Andrew Lo, a finance professor at the Massachusetts Institute of Technology who also manages quant funds. That is, they need to focus on the adaptation to changing environments that characterizes the biological realm, rather than the sort of immutable laws that form the foundation of physics. While quant managers might like to think that three laws govern 99% of investor behavior and thereby drive securities prices, he says, “we’re lucky” if 99 laws explain even 3% of investor behavior. A number of mutual funds that employ multiple external managers and strategies are taking a step back from quants. While quant strategies can play a role in such funds, “they need to be a limited component,” says Lee Schultheis, president of Hatteras Alternative Mutual Funds. In his Alpha Hedged Strategies, he now allocates about 15% to quant strategies, down from more than 20% previously. But investors shouldn’t dump quants completely, advisers say. “In a world filled with more data than any of us can digest, there’s a need for quantitative tools to sift through it all,” says Rick Lake, co-chairman of Lake Partners Inc., which creates and manages alternative-investment funds using multiple managers.