An NFO that’s currently open is DSP Quant, a differentiated offering from DSP fund house. DSP Quant is an equity fund that will pick stocks based on quantitative models. In using such models, the fund seeks to avoid pitfalls that come from personal biases, or fund managers going wrong in market timing or predictions. At present, there is no equity fund following quant/ factor-based investing, barring Reliance Quant.
Model and portfolio
Quant or factor-based models are built by considering a stock universe and applying a variety of factors or filters. Factors are metrics based on which company financial strength and growth can be judged.
DSP Quant will use the BSE 200 index as the base. Therefore, the fund will have a marked large-cap tilt. DSP Quant aims at building a portfolio of quality stocks with reasonable valuations and low volatility. It does this in three ways.
- Weed out sub-par companies: The model seeks to filter out highly leveraged or where the management is not aligned to shareholder interest. It also excludes companies whose earnings are not of good quality, i.e., where there could be manipulation of earnings. Finally, it also weeds out volatile and high-beta stocks. To gauge all this, the model uses a wide range of metrics, ranging from EBITDA to cash flow, debt to equity, market capitalisation, credit ratings, working capital cycle and so forth. Eliminating weak companies narrows down the field to quality and stable companies.
- Identify sound companies: From the smaller universe of stocks, the model then looks for stocks that are good – which boils down to companies that are growing well and are reasonably valued. Metrics used here include return on equity, earnings growth and its consistency, consensus earnings growth, dividend yield, and such.
- Ensure diversification: In order to avoid concentration, the fund will go up to 5 percentage points overweight on a single stock compared to its weight in the index. Similarly, active weight on sector exposure will be capped at 10% compared to index weight.
The quant model assigns stocks scores for each factor, based on which the final portfolio will be drawn up. The portfolio will be rebalanced every half year, to account for new information, book profits or exit stocks that don’t meet the criteria, or include new stocks.
Source: AMC. Based on back-tested data. These figures pertain to the performance of the index and do not in any manner indicate the returns/performance of the Scheme. It is not possible to invest directly in an index of the quant model.
The pros and cons
- Investing based on quant or factor models are firmly established in global markets.
- Factor-based investing reduces the effects of the fund manager taking the wrong calls or being influenced by the need to prop up short-term returns.
- The factors used are typically tested across market cycles and are comprehensive covering fundamentals and prices.
However, factor investing may be unable to spot smaller or qualitative factors that fund managers and analysts can catch. Models may also be unable to “discover” stocks, which can often turn out to be strong performers; a focus on long-term quality may also lead to missing out turnaround stories or shorter-term opportunities. Quant models may underperform during sentiment-driven or euphoric rallies.
Like all other equity funds, DSP Quant too will not be immune to market volatility although it may reduce it. It, therefore, needs a long-term holding like other equity funds.
This fund is distinctive in terms of strategy. With shrinking margins of outperformance among large-cap funds, quant strategies may be able to deliver better. Therefore, the fund can serve as an addition to an existing portfolio of diversified equity funds.
It would need a moderate to high-risk appetite; while the portfolio would be large-cap dominated, the fact that it is an NFO ups the risk. Holding period needs to be much longer as well. The AMC itself has pegged minimum holding period at 7 years since quant models can underperform in some market cycles.
The NFO is open until June 3rd.
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