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Bargain-Hunting By Computer: Data Drive Investment Decisions for Vanguard Group's High-Performance Quantitative Funds. Soon, Smaller Investors Will Be Able to Get the Vehicle

Posted on: Monday, 20 February 2006, 03:03 CST

By Todd Mason, The Philadelphia Inquirer

Feb. 20--One of the fastest-growing stock-picking operations in the Philadelphia area is run by an unlikely crew: seven computer jockeys managing Vanguard Group's quantitative mutual funds.

This offshoot of Vanguard's trademark index-fund operation oversees $18.7 billion in 11 actively managed funds, up from just $3.7 billion at the start of 2001.

Quantitative investors use computers to find undervalued stocks. "It is basically doing the same things" that conventional managers do, said Joel Dickson, who heads the group.

But "we don't meet with company management," Dickson said. "We solely let the data drive our decision-making."

Dickson's group works mostly in the background today, managing money for institutions and pieces of huge Vanguard funds such as Windsor II and Morgan Growth. Its only solo mutual fund is the $5.6 billion Strategic Equity fund.

But Strategic Equity's strong performance is raising the quant group's visibility. Vanguard expects to start a second all-quant fund, Strategic Small-Cap Equity, in April.

More quant funds are coming, said George U. Sauter, Vanguard's chief investment officer. "Our goal is to grow this part of our lineup," he said.

Quant funds are a natural outgrowth of index funds, which aim simply to keep pace with a basket of stocks representing the market or a corner of it.

Also using an index as a base, Dickson and his staff sift through the stocks, ranking each from 1 to 10 on measures of potential risk and gain.

Then, in a second computer run that can take 2.2 billion calculations, the computer assembles the combination of No. 1's and No. 2's that most closely resembles the makeup of the base index, holding a similar percentage of assets in energy stocks, for example.

"It is quasi-indexing," said John Bogle, Vanguard's founder, who launched Vanguard's first quantitative mutual fund in 1986: the $7.4 billion Vanguard Growth and Income fund. (Unlike Strategic Equity, Growth and Income is managed by an outside advisory firm.)

"I've owned it from the very beginning" in a retirement account, Bogle said of Growth and Income. "In a taxable account, it is probably a bad bet" compared with the underlying index fund.

Quant funds incur more taxes because they trade more frequently than index funds and thus pile up greater capital gains.

Not all quant funds are the same, Bogle cautioned. The more aggressive the fund is, the greater the tax burden and the higher the risk, he said, and investors need to do their homework.

There is also the chance that the computer model will choose the wrong stocks. Dickson says that his group's No. 1 picks outperform similar stocks about 60 percent of the time. Roughly the same percentage of No. 10 picks underperform.

But quants argue that computers are superior to humans in the two scenarios that create most investing opportunities. They aren't beguiled by skyrocketing share prices or cowed by implosions.

Quants are "people who are taking some pains to engineer a process that has been strictly seat-of-the-pants," said Kevin Johnson, a principal at Aronson Johnson Ortiz L.P.

The Philadelphia quant shop is climbing an even higher trajectory than Vanguard's quants in Malvern, managing $24.4 billion today for 91 institutional clients, up from $4.3 billion five years ago.

Some of it is simple luck, Johnson acknowledges. Quant managers typically search for stocks of small and medium-size companies selling at bargain prices. These small-cap and midcap value stocks, as they're called, have dominated the market since the technology bubble burst in 2000.

Strategic Equity shined as well in the five-year period ended Jan. 31, according to Morningstar Inc. Its average annual return of 12.7 percent beat 88 percent of the funds that the Chicago fund-ranking firm considers its peers.

Strategic Equity also beat its base indexes over that period, by 3.2 percentage points. (The fund switched benchmarks in 2003.)

That isn't to say its current index, maintained by Morgan Stanley Capital International Inc., performed shabbily. The MSCI U.S. Small Cap and Mid Cap index gained 22.2 percent in the 12 months ended Jan. 31, beating Strategic Equity by a percentage point.

"The only way you win in active management is to systematically take advantage of someone else," said Sauter, Vanguard's top investment strategist.

In the quant world, this Darwinism is spurring a digital version of the arms race. "Every year you have to run faster and faster, because only the smartest survive," he said.

Contact staff writer Todd Mason at 215-854-5679 or tmason@phillynews.com.

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Source: The Philadelphia Inquirer

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