High-octane INTECH quant strategy dinged by volatility

INTECH’s large-cap quantitative growth equity strategy, long a high-performance engine for the firm, has been stumbling just as a spike in capital market volatility is raising broader questions about the robustness of quantitative strategies. A string of five lagging quarters, accentuated by a painful 3.4- percentage-point shortfall for the three months ended June 30, produced an annualized return of 8.58% for the three years through July 31, below the 9.02% return for the strategy’s S&P 500/Citigroup growth equity benchmark. Longer term, the flagship strategy of the Palm Beach Gardens, Fla., firm — formally Enhanced Investment Technologies LLC — remains well ahead of its benchmark. For periods ended July 31, the strategy’s annualized five-year return is 11.3% versus a benchmark return of 9.01%, while the 10-year annualized return is 10.1% versus a benchmark return of 4.37%. Feeling the most pain are the clients who hired INTECH in recent years. According to eVestment-Alliance of Marietta, Ga., INTECH’s growth strategy has taken in more than $8 billion in institutional assets since the beginning of 2004. Factoring in market appreciation, that would mean client portfolios accounting for roughly half of the strategy’s $18.5 billion in assets as of June 30 are trailing their benchmark. A number of consultants to pension funds said INTECH executives either have met with them in recent weeks or have made appointments to do so. One veteran consultant, who declined to be identified, said INTECH is, in many cases, the only large-cap-growth manager for his clients, and the recent underperformance has been especially painful, because growth stocks are outpacing value for the first time in years. INTECH executives say the mathematical models that drive the firm’s strategies aren’t broken and should continue to deliver healthy gains over time. Robert A. Garvy, INTECH’s president, chairman and chief executive since 1991, said staying in touch with consultants and clients is “absolutely imperative,” especially after stellar returns between 2000 and 2005 left many focusing on other, more pressing problems. With a rough second quarter following modest underperformance in 2006, “now we’re one of the problems,” and it’s only natural that clients would be asking whether the process is broken, he said. INTECH’s rough patch comes at a time when investors’ faith in quant managers in general has been shaken, with the volatility of the past month or so hurting some long-only quant strategies and blowing up a number of hedge funds. It’s an environment where investors have to ask whether the “things that drove performance in the past have been arbitraged out of the market,” said Jeff Gabrione, the Chicago-based head of Americas manager research with Mercer Investment Consulting of New York. Some industry players say the opaqueness of INTECH’s process will complicate its efforts to reassure clients. It might not be justified, but INTECH is “so mysterious in how they outperform that it wouldn’t take much for people to lose faith in them,” said the head of a competing quant firm, who declined to be identified. But Mr. Garvy said INTECH is the opposite of a “black box.” He noted that the mathematical underpinnings of its models are spelled out with scientific precision in papers on the company’s website by E. Robert Fernholz, chief investment officer. Mr. Garvy concedes that INTECH’s process differs from most quants, which simply employ more disciplined tools to do what fundamental managers do in identifying undervalued stocks to buy and overvalued ones to sell. By contrast, INTECH’s process doesn’t depend on predicting the direction of stock prices, focusing on the relative volatility of stocks to each other, he said. “There’s a natural tendency to want to put a narrative around events … explaining things in terms of the subprime meltdown or too much exposure to financial stocks,” but that turns out not to be useful in INTECH’s case, Mr. Garvy said. Still, he said, INTECH is getting “surprisingly good feedback” from clients and consultants. Alan D. Biller, president of Menlo Park, Calif.-based pension consultant Alan D. Biller & Associates, is among those satisfied with INTECH’s assurances. The firm’s models depend on an equilibrium model for volatility co-variances, and the markets “haven’t been close to equilibrium recently,” he said, adding “I’m not really worried” about the recent underperformance. At this point, defections have been modest, with the growth strategy — after years of heavy net inflows — seeing net outflows of $67 million during the first six months of 2007. And while many quant firms have been hammered by the credit crunch since July, INTECH has emerged relatively unscathed. Mr. Garvy said that halfway through the current quarter, the firm’s large-cap-growth strategy is trailing its benchmark by about 0.5 percentage points, while other strategies, such as the enhanced index strategy, are ahead of their benchmarks.