A new mutual fund, from investment banking group Capital Alliance, is aiming to combine the smarts of fund managers with insight from mathematical models. CAL QE Fund, a quantitative equity fund, will be launched in a month according to the team which designed it. “Quantitative models work well in imperfect markets like Sri Lanka, where there is a time lag before information is factored in to the price and we are exploiting that time lag,” explains Dr Naveen Gunawardane who heads investment banking at Capital Alliance, the company behind the quant fund.
Quantitative funds use mathematical formula to track a number of variables about a company’s financial health defined by its managers and rank the firms it tracks. Quantitative funds operate as hedge funds as well as mutual funds. However hedge funds, which don’t exist in Sri Lanka, are only open to sophisticated and high-net-worth investors whereas mutual funds can be marketed to the public.
Capital Alliance believes their QE Fund, a mutual fund, still may not appeal at first to a broad investor segment because of the products unfamiliarity in this market. However investors with greater financial literacy, pension funds and private equity portfolios may find the relative sophistication and greater equity risk diversification, attractive. CAL QE Fund’s managers back tested, or applied the quantitative model for a period covering the last six years, with encouraging results. While the market (ASI) returned 16% annually, the CAL model portfolio returned 35% a year, during a period when the market was initially in bear territory, which was followed by a bull run and a painful market correction. Capital Alliance fund managers, who are already marketing the quant fund and expect to have Rs250 million invested at its launch, realize back test results won’t be enough to attract wide interest. “The real money will come in after we show performance,” admits Gunawardane.
CAL QE Fund screens a universe of around 90 stocks, about a third of listed companies here, based on 25 to 35 factors every trading day. The measures look at the health of a company and are mostly ratios on the balance sheet, cash flow, dividends, P&L and earnings. Because it’s proprietary the fund’s managers don’t provide a comprehensive list of all the factors they are tracking and the weights assigned to them. “It identifies the above average companies that are trading at below average prices,” explains Ashveeni Shanthikumar who heads Investment Management at Capital Alliance Investments. “Just because the stock is undervalued it does not get picked up, it also has to be an exceptional business at a below average price,” he explains. It’s designed as an open ended fund so investors can enter and exit anytime and will have a performance fee for the management if investments offer good returns.
The CAL QE Fund has a three step process before its fund managers decide to buy a stock. In the first step its algorithmic model will rank the 90 or so of the most liquid stocks in to five pools, with the most attractive going in to the top pool and the least attractive going to the bottom. Secondly the fund’s managers use more quantitative techniques to allocate funds in ways to minimize wild swings in the portfolio. “Again we take the human element out of it,” explains Gunawardane who has experience developing quantitative trading strategies for fund managers during his time at AMBA research Sri Lanka. “Let’s say we identified 10 stocks that we would like to allocate funds to and we run an optimizer that would construct a portfolio for us with the lowest volatility.”
Once the mathematical formula are fed in to the systems the first two steps can run without human intervention, precisely why the fund has a third step requiring fund managers to look at the outcomes and make the portfolio allocation. “We didn’t want to completely remove the human element. But that’s the exception and not the norm, if a punting stock comes in we won’t invest in it,” adds Gunawardane.
The markets lack of sophistication means investors won’t get the full benefit of a quant mutual fund. While managers invest in the top ten to fifteen best ranked stocks they track; the worst ones they will sell short (sell borrowed securities expecting prices to fall). “But we can’t do that here, so we are going on a long only strategy,” says Gunawardane.
Shanthikumar who has experience with a quant hedge fund in London and the quant team at AMBA here explains the quant stock picking process has risk management built in to it, “risk management is not something we think about after, we are actually building risk management in to the process because we are looking at volatility, market cap and draw downs.”