Funds that use quantitative stock-picking models are on a roll. A list of 52 U.S.-sold quant funds compiled by Morningstar beat more than 80% of their respective peers over the trailing three years through June 13, and the group outperformed its respective peers in 2011, 2012, 2013, and thus far in 2014.
This hot streak represents a remarkable performance turnaround. 2007-09 was a rough stretch for quant funds. The bear market that kicked off in late 2007 was marked by a sharp reversal of the prior five years of strong performance. Since many quant funds rely to a significant degree on models that track earnings and/or stock-price momentum, the funds were hit especially hard by the bear market, when sharp reversals tripped up those models. Quant mutual funds were also hurt in the bear market when their quant-oriented, hedge fund cousins started dumping commonly held stocks, driving down share prices. Making matters worse, some quant funds then rotated from economically sensitive firms into defensive fare, which held up relatively well in the downturn, only to get left behind again when a rebound began in earnest in March 2009.
As a result, our list of funds performed poorly for three consecutive years: They posted median category ranks of 67 in 2007, 56 in 2008's sharp decline, and 58 in 2009's big rebound. Even in 2010, by which time the market had somewhat calmed down, their median category rank was a middling 47.
A Less Bumpy Path
So what has changed during the past three years? For one thing, the stock market got less volatile. Since the second quarter of 2010, the S&P 500 has only posted three negative quarters of returns, and it declined more than 2.8% in only one of those periods (2011's third quarter, when the index lost 13.9%). Thus, momentum-based models have had upward trends to latch onto. On a related note, correlations between individual stocks' returns (which typically spike in downturns) have declined.
There are other factors, too. Big outflows from quant mutual funds and hedge funds means the crowding effect that can reduce the effectiveness of quant models' signals has been lessened. Also, a few of the weaker performers from our list have been liquidated or merged away, while others have seen manager and strategy changes and now employ a fundamental approach.
Some quant teams have also stepped up their game. Bridgeway, which runs seven actively managed quant funds, re-engineered its models to better handle periods when correlations are higher, and its lineup's performance has markedly improved since that process was completed at the end of 2011. (The flagship of that lineup is Bridgeway Aggressive Investors (BRAGX).) Goldman Sachs has 10 quant funds on our list, and their performance has modestly improved since Ron Hua took over the quant team in 2011 and introduced new factors. Of course, as we noted above, there haven't been any sharp downturns over this stretch.
Caution Is Still Warranted
It remains to be seen how quant funds will hold up when stocks go south for an extended period again. And given their elevated valuations following a five-year rally, equities could turn volatile sooner rather than later.