Edelweiss is one of the few fund houses that actively employs quant models as an intrinsic part of its equity portfolio construction strategy. As Paul explains, quant models can be used both as a risk management mechanism or as an alpha generation engine. When used for both, you tend to get a more stable portfolio performance, which balances out the quest for alpha with the much needed downside protection. Read on as Paul explains how he and his team use quant models to manage their equity portfolios, his outlook on equity markets and his analysis of the performance of his flagship equity funds.

WF : Quant models and their application in equity management are as yet relatively less understood in our market. Are quant models primarily a risk management mechanism or an alpha generation mechanism?

Paul : Quant models used by Edelweiss Asset Management Ltd. (EAML) are basically fundamental factor models. A factor can be thought of as any characteristic of a security that is important in explaining their return and risk. So factor models can be used to calibrate risk as well as returns. Hence, depending upon the mandate, factor models can be used for risk management centered products or alpha generation oriented products.

WF : What are the contours of the quant model that you use and how do they impact management of your actively managed equity funds?

Paul : EAML primarily uses Quality, Value and Safety as the dominant factors in its portfolio building approach. This ensures that portfolios predominantly constitute of High Quality Growth stocks which are available at reasonable price. The safety feature of the portfolio construction process endeavors to reduce the downside of the portfolios as compared to the market. Since wealth is generated predominantly by compounding returns i.e. by being invested in the market over longer periods of time - negative returns are likely to reduce the compounded value of the portfolio significantly over the longer term. Thus, safety feature creates a preference for stocks in the portfolio that will fall less than the market in case of a down move.

WF : Markets are buoyant, but opinions are divided with some calling it a secular bull market and others calling it a Modi hope rally. What is your take on markets for this financial year and what do you see as the key drivers?

Paul : India has been growing at the lower end of historical growth range for a few quarters now. Macroeconomic situation is improved significantly as compared to the middle of the last year. However, earnings are eagerly awaited for signs of any bottoming out. Earnings for India Inc. haven't been upgraded - but the multiples have been.

Multiples are a function of sentiment - which has definitely improved. Now, whether this multiple expansion is on the hope of stable government post elections, or being the best available option in BRIC for FIIs or on some early green shoots in the economy - it is hard to tell as of now. Election results will be out in mid May and corporate earnings and Budget will be out by June. Picture would be much clear then as to what this is. Our opinion is to let the data drive the decision rather be driven by the vagaries of Mr. Market which is known to move from despair to euphoria and the other way around on a moment's notice.

As we look out on the fiscal year 2015 - there are a lot of known unknowns and then some unknown unknowns. The known ones include domestic elections, sticky consumer inflation, private sector capex revival, US FED monetary policy, slowing growth in US and EU, defaults in China and geopolitical tensions. The unknowns will also surely surprise us. It will be a year where the cost of money is likely to go up and growth expectations across a lot of economies will get tested. For India, on the other hand, interest rates are likely to stay flat to negative. However, the growth and revival question will hang over the economy. High hopes have been pinned on the election outcome in May. The results will determine the sentiment and the policy actions thereafter will determine the growth. We are cautiously optimistic on both.

WF : Your MidCap Fund had a poor 2012 (Alpha : -4.95%, 4th quartile) which was followed by a very impressive 2013 (Alpha : +16.8%, 1st quartile). What led to the poor performance in 2012 and what were the changes you made that enabled a strong performance in 2013?

Paul : As mentioned above, the three pillars for EAML portfolio selection are Quality, Value and Safety with Quality being the dominant factor. Now when markets are extremely valued (high or low) or valuation dispersion between various sector becomes very high - value becomes the dominant factor that will explain the market returns going forward. So portfolios with a value orientation do much better and quality and safety suffer. This was the case in 2012. Markets usually operate in the middle zone, but every once in a while valuations get out of hand or the valuation difference between cyclical and defensive sectors becomes too high. We have started to take into account such scenarios in our portfolio construction - giving more importance to value factor. Our portfolios are likely to perform better in such extreme cases going ahead.

WF : Your EDGE Top 100 Fund has done well in the last 3 calendar years - 2011, 2012 and 2013, with healthy alpha in all 3, top quartile rank in 2 out of 3 and 2nd quartile rank in 1. What are some of the factors that have helped drive this consistent performance?

Paul : The three pillars for EAML portfolio selection are Quality, Value and Safety with Quality being the dominant factor. Because of a lack of growth in general over the last 3 years, people have trusted quality and safe stocks with their money and this has helped EDGE Top 100 do well.

WF : The first quarter of this calendar year (Jan-Mar 14) has started off on a relatively weak note for both these funds. In your attribution analysis, what are some of the key calls that detracted from performance? Have you made any changes in portfolio strategy in recent weeks consequent to a poor quarter?

Paul : As mentioned above, when markets are extremely valued (high or low) or valuation dispersion between various sector becomes very high - value becomes the dominant factor that will explain the market returns going forward. So portfolios with a value orientation do much better and quality and safety suffer. Such is the case in Q1 2014 as well. As we mentioned above, we have added some more of value factor in the portfolio. However, the growth data is still not entirely supportive of investment in certain sectors in the market like PSU Banks and Capital goods.

Disclaimer: Mr. Paul Parampreet is the Head of Equities at Edelweiss Asset Management Limited and the Fund Manager of all the equity schemes of Edelweiss Mutual Fund. The views expressed above are his own and should not be construed as investment advice. Recipients must make their own investment decisions based on their specific investment objectives and financial positions by taking suitable competent advice. Edelweiss Asset Management Limited (EAML), Edelweiss Trusteeship Company Limited or any of its Directors, Officers, Employees and personnel do not accept any responsibility for the editorial content or its accuracy, completeness or reliability and hereby disclaim any liability with regard to the same.

Edelweiss Select Midcap Fund and Edelweiss Diversified Growth Equity Top 100 Fund are open ended equity oriented schemes of Edelweiss Mutual Fund. These schemes do not provide guaranteed/assured returns.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

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