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Oct. 1, 2010, 1:29 p.m. EDT

Bruised Quant Funds Seek a Human Touch

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By Eleanor Laise

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.

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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 /zigman2/quotes/209325896/composite MORN -0.15% 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.

Missteps and Missed Signs

It became painfully apparent in recent years that many quant funds were focusing on the same types of data to pick stocks. So as some of these portfolios began to stumble, they all suffered in unison.

While quant models can vary greatly from one fund to the next, they often focus on value measures such as a stock's price-to-book-value ratio or price-to-sales ratio. Also popular are momentum factors such as a stock's performance over the previous 12 months.

As markets grew choppy in the summer of 2007, the selling pressure spread quickly among quant funds. Models that previously seemed to have low correlation with one another began to head south simultaneously.

"It didn't matter how good the manager was at portfolio construction," says Chris Thompson , head of the global equity manager research team at Rogerscasey, which helps investors research and select money managers. "Everything got blown out of the water because of this overcrowding" of quant trades.

Troubles continued in 2008 and 2009. As the financial crisis punished stocks across the board, many quant funds were attracted to beaten-down value plays that only continued to sag.

"We incorrectly thought stocks were cheap and dove in and got pummeled," says Craig Callahan , president of quant firm Icon Advisers Inc. Icon Core Equity falls near the bottom of its large-cap blend category over the past one-, three- and five-year periods, according to Morningstar.

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