* Managers often rely on third-parties
* Use of outside research may cost investors
By Jessica Toonkel
NEW YORK, June 28 Usually proprietary means
exclusive. But when it comes to quantitative equity models that
some mutual fund managers charge a premium for, proprietary is a
matter of degree.
Even fund managers disagree about the definition of
proprietary. To some, it refers to models they built with
third-party data. Others use it to describe their own
personalized version of someone else's quantitative investing
"Quite often managers will pitch us their process and they
will claim it is differentiated but that is not always entirely
the case," said Stephen Miles, senior investment consultant and
manager of research in the London office of Towers Watson
That grey area means that investors in these so-called quant
funds may have to do more digging into their managers' process
to make sure they are getting what they are paying for.
Quant funds generally cost slightly more than non-quant
funds, according to Lipper. Investors may ignore the premium
because they think a proprietary quant model with a secret
formula gives them an edge.
The ambiguous meaning of "proprietary" became evident most
recently at BlackRock Inc.
Earlier this year the New York-based firm changed the
prospectus for its $3.7 billion Large Cap Series to show that
the models for the funds were "generated by third-party research
firms." Previously, the prospectus had stated that a
"proprietary multi-factor quantitative model" formed the
investing strategy for the three funds.
The funds' manager, Bob Doll, had always used third-party
models. But he had customized them, "applied relative
weightings," and added his own fundamental analysis to construct
a portfolio, he said in a statement.
Doll is retiring from BlackRock Friday.
Some managers of quantitative equity mutual funds use
third-party models and tweak them to some degree while others
bring third-party data into their own models, experts said.
For example, J.P. Morgan Asset Management, the asset
management arm of JPMorgan Chase & Co, uses earnings
estimates from third parties and MSCI's Barra software to help
assess and manage risk, although the rest of its model is
constructed using its own tools.
"I would describe that as proprietary, but one could say it
isn't," said Dennis Ruhl, chief investment officer of the firm's
behavioral finance group. "There does tend to be a grey area."
There are typically three steps to a traditional,
quantitative equity fund manager's process: choosing or building
the models, determining the weightings of the portfolios after
running figures through the models, and constructing the final
portfolio based on the models and other analysis, experts said.
That last step is usually proprietary, but the first two
steps can be outsourced to third parties, said Vadim Zlotnikov,
chief market strategist at Bernstein Research, a unit of
"If a manager thinks they are adding value through the
portfolio construction, that is what they focus on," he said.
QUESTION OF VALUE
Some managers believe that it is difficult to provide
differentiated returns by relying mostly on third-party models.
For one, third-party models used by fund managers may only
work for so long, said Sandip A. Bhagat, a principal and global
head of equities at The Vanguard Group. The research firms that
create them typically sell them to multiple fund managers.
"There is nothing unique about your insights and if enough
people have access to that concept, money will chase the idea to
the point that the idea just stops ... providing good returns,"
he said. Vanguard uses proprietary models, said Bhagat.
For the past five years, long-only quantitative equity funds
are down 2.38 percent, compared to non-quant equity funds, which
have fallen 1.07 percent, according to Lipper.
Investors need to be informed clearly, said Russ Kinnel,
director of mutual fund research at Morningstar Inc.
"Investors need to know how their managers are using third-party
research and what else is going into that process."
A manager relying largely on third-party models and research
should charge less than those who are primarily relying on their
own models, Kinnel said.
The average expense ratio for quantitative equity funds is
1.12 percent, compared to 1.04 percent for non-quant funds,
according to Lipper.
What's more, third-party research and models are typically
paid for with "soft dollars" - or through commission revenue
rather than through direct payments.
"Ultimately, these payments are shaving returns off the
funds," said Harold Bradley, chief investment officer (CIO) for
the Ewing Marion Kauffman Foundation, who oversees his own
proprietary quant investments for the foundation. "It is not
transparent at all."