Quant and passive funds are apples and oranges; Do not get confused while comparing them

This article is authored by Siddharth Vora, Head of Quant Investment Strategy and Fund Manager, PL Asset Management.

Quant funds are often mistaken for passive funds because they both rely on rules-based strategies without the daily involvement of active fund managers. But let’s be clear: they are quite different.

What are passive funds?

Passive funds aim to replicate existing benchmarks, such as the Nifty 50 or the Nifty PSU Bank, tracking the market rather than trying to outperform it. The two main types are index funds and ETFs (exchange traded funds).

Passive funds include Sector and Theme-tracking funds such as IT, pharma, banks, manufacturing, infrastructure, EV, etc; Style and Factor funds such as value, momentum, quality, dividend, etc; Size and Market cap-based like Nifty Next 50, Nifty 100 Equal Weight, Nifty Mid cap, Small cap, Nifty Micro cap etc.

Passive funds are gaining popularity in India, now making up about 17 per cent of the total assets under management in the mutual fund industry, compared to 7 per cent five years ago. They are great for beginners or investors who prefer a low-cost investment option, aiming for benchmark returns with minimal tracking error. Passive funds are simple to understand, easy to implement and carry no key man risk.

In contrast, quantitative investing takes an active approach. It is driven by data models or algorithms backed by quantitative analysis and designed by experts. Quant funds adjust dynamically using metrics like fundamentals, technicals, macros, liquidity and risk. The key difference is that quant fund managers enjoy greater flexibility than passive fund managers.

Passive funds follow rules to strictly replicate benchmark allocation and performance, while quant funds follow rules to differentiate from benchmark allocation for outperformance. It is as simple as that!

While passive funds are typically restricted to a single sector, factor, or investment universe, quantitative strategies can adapt to changing sectors, styles, and themes using multiple factors for dynamic allocation. This multi-factor approach makes quant funds more flexible.

Outperformance of quant

Quant investing begins with the design of complex models. This is where the active management part of quant strategies comes into play. These models handle everything from filtering red flags in stock to assessing liquidity and price action, as well as evaluating a company’s growth parameters. Every asset management house has a different approach, making quant models unique from each other.

For example, while dynamically allocating across assets in our multi-asset quant PMS, we objectively evaluate relative asset class valuations, volatility and trend. We also assess monetary, macro and market cycles to gauge inflation, bond yields, global growth and risk appetite. This analysis determines the allocation split between equities, bonds and gold.

Similarly, in our long-only flexicap equity quantitative strategy, AQUA, we examine over 25 proprietary factors — such as quality, growth, value, dividend, momentum, volatility, liquidity, theme, style, volume, size, and sentiment — analysing more than 1,000 market indicators to build the portfolio.

AQUA integrates dynamic style alignment, sector rotation, smart risk and beta management to align with prevailing macro and market regimes, blending the trinity of fundamental, valuation and technical for stock selection.

Quant funds’ outperformance is unmatched. Data compiled by our team shows that 84 per cent of quant funds have outperformed their benchmark in the past year. In comparison, only 42 per cent of active funds outperformed the benchmark in the past year.

Over three years, 78 per cent of quant funds outperformed the benchmark, while the same number for active funds was 54 per cent. Over a longer period of 10 years, a whopping 100 per cent of quant funds have outperformed the benchmark compared to only 47 per cent of active funds.

This shows that eliminating emotions and biases to generate performance using a systematic process has globally proven to be a more reliable way of managing money for repeatable outperformance. This approach is devoid of key man risk. AQUA has generated a return of over 75 per cent in the past one year, delivering alpha of over 35 per cent versus BSE 500, which is a testament to the potential of quant in India.

Shielding against known risks and responding to unknown risks

Passive funds cannot move into cash when market conditions deem it necessary. On the other hand, quant strategies can manage risk by reducing beta, moving to cash, shifting to defensive sectors, adjusting style tilts, increasing exposure to large caps, hedging with derivatives, or allocating to negatively correlated assets like gold.

For example, during periods of market volatility driven by geopolitical uncertainty or ambiguous interest rate trajectories, quant funds have the flexibility to keep dry powder. In contrast, passive funds do not have the liberty to make such tactical adjustments.

In essence, quantitative strategies can adapt to market changes for risk reduction, capture opportunities and exploit market inefficiencies, using data-driven models.

Cost vs Risk-adjusted return profile

Passive funds boast lower costs in terms of management fees and trading expenses due to lower churn. The portfolio is balanced only when the benchmark composition is changed, semi-annually or quarterly. However, they do not necessarily mitigate risk or yield higher returns compared to the benchmark index they track.

In contrast, despite higher associated costs, quant funds have the potential to implement strategies that lower risk or aim for superior return, thereby targeting a more favourable risk-adjusted return profile.

In a nutshell

In India, quant holds massive potential. While overall quant AUM has grown 338x over the past 10 years, from Rs 271 crore in 2013 to Rs 91,443 crore in 2024, its market share is barely 1.5 per cent in the Indian asset management space.

When it comes to investing in either passive or active, investors should choose the type of fund that aligns with their financial goals and risk tolerance. When making investments, comparing an apple with an apple makes more sense compared to comparing apples with oranges.