Canadian mutual fund managers seeking to differentiate themselves from the pack are increasingly turning to quantitative strategies to help them make complex investment decisions.

Portfolio managers at London, Ont.-based Highstreet Asset Management Inc. are putting their expertise in quantitative analysis and risk management to work for their parent company, AGF Funds Inc. Toronto-based AGF recently unveiled a trio of funds managed using quantitative investment techniques: AGF Canadian All Cap Equity, AGF Global High Income and AGF Global Balanced High Income funds.

AGF joins a handful of other firms using quantitative methods to manage one or more mutual funds, including Franklin Templeton Investments Inc. of Toronto and Hesperian Capital Management Ltd. of Calgary.

Quantitative funds, known as “quant” funds, are managed using complex mathematical or statistical models to generate stock picks. Computer programs are set up to screen and rank potential investments according to parameters determined by the manager, such as a company’s earnings growth momentum, the stock’s yield or market valuation.

With such programs, the grunt work of analysing securities and executing trades can be partially or fully delegated to the model, depending on the manager’s style.

Robert Jackson, senior vice president of investments at Highstreet, says the firm uses a bottom-up, “factor-based” approach to portfolio management.

“We find that the single most powerful driver of stock market performance in Canada is short-term earnings momentum,” he says. “We tailor a set of factors specific to each mandate.”

After the companies have been ranked using earnings growth and other factors, potential holdings are selected from the top 25% of the list. Jackson says about 80% of the stock-picking process is model-driven, while 20% is a fundamental overlay. Highstreet has also developed a proprietary risk-management system that is integrated with the factor-based approach.

“We have a heavy emphasis on risk management,” says Jackson, noting Highstreet’s investment team is co-led by its chief investment officer and chief risk officer.

For example, AGF Canadian All Cap Equity Fund — which focuses on companies with above-average growth prospects, as determined by analysing earnings momentum — also maintains a very specific risk tolerance. The portfolio is designed such that the fund’s risk, as measured by volatility, ranges from 90% to 150% of the volatility of the TSX/S&P composite index.

“It allows us to make sure we’ll be compensated for the risk when we do take risk,” Jackson says. “Our measures will calculate a risk-adjusted return.”

Since Highstreet was established almost 10 years ago, returns on its Highstreet Canadian Equity Fund have outstripped the S&P/TSX composite index by five percentage points a year on an annual basis.

Looking for undervalued stocks with momentum is also the goal of Keith Leslie, portfolio manager, vice president and partner at Hesperian. He uses his model to analyse 800 companies as potential investments for Norrep Q Class Fund.

Leslie’s model produces a selection of about 130 large- and mid-cap Canadian equities with strong momentum in price and earnings. Leslie then scours the list for value, looking at indicators such as low price/earnings multiples to reduce the list to about 30 holdings.

Leslie’s “black box plus human judgment” strategy has resulted in Norrep Q Class delivering an average annual compound return of 18.2% for the three years ended Dec. 31, 2007, compared with an average return of 14.3% for the fund category. However, the fund’s one-year return was only 6.1%, compared with 7.4% for the category.

“The past three months have been difficult for momentum managers, value managers and mid-cap managers,” Leslie says. “So, for us, it has been the perfect storm, as we have tried to marry these three strategies.

“We believe that we have a unique product with Norrep Q, in that it places an emphasis on value as well as momentum,” he adds. “We also try to buy the best companies for our portfolios, regardless of the market cap, which has led us into the mid-cap market.”

This has meant weak relative and absolute performance over the past three months, resulting in Morningstar Canada downgrading Norrep Q Class to four stars from five. In mid-2007, the fund’s three-year return was among the top five Canadian equity funds in the country. At yearend, it was still in the top 15.

“We believe that our methodology will return to favour in the near future,” Leslie says, “and our absolute and relative performance will improve.”

@page_break@Before Leslie became a partner at Hesperian, he worked as a quant analyst for Bissett & Associates Investment Man-agement Ltd. , a Calgary-based subsidiary of Toronto-based Franklin Templeton. Leslie left three years before Bissett established Bissett All Canadian Focus Fund, its quant fund, in 2004.

Unlike Leslie and Highstreet’s Jackson, the Bissett fund’s co-manager, Jason Hornett, rarely intervenes in the model. “We really stay hands-off,” he says.

“For me, it’s all about the relative attractiveness of the securities,” he adds, noting banks rarely make it to the top of his list.

At about 30%, the Bissett fund is overweighted in materials and, at 7%, underweighted in financials, the latter proving to help the Bissett fund’s performance during the recent downturn sparked by the credit crunch.

“Just being underweighted on the financials helped us outperform the index,” Hornett says, noting that weighting distinguishes his fund from most other Canadian equity funds.

The Bissett fund’s one-year return is 11.5%, outperforming both the S&P/TSX composite (9.8%) and the average return in the Canadian equity category (7.4%). The Bissett fund’s average annual compound return for the three years is 15.7%, vs 17% for the category.

“The main benefit of owning this fund is style diversification,” Hornett says.

The quant management style is not as common in Canada as in the U.S. In launching the three AGF/Highstreet funds, AGF recognized it would have to spend time educating advisors about the strategy, says Randy Ambrosie, president of AGF.

“We’re certainly talking about Highstreet’s investment style, and you can’t do that without a strong emphasis on the quantitative nature of its investment platform,” he says. “It always sparks a really interesting conversation, because while it is nothing new, it is certainly not widely used.”

The key factors for the tax-efficient AGF Global High Income Fund are quality, earnings growth and dividends. The equity portion of the portfolio will aim for a higher yield than the MSCI world high dividend yield index.

Of benefit to investors who want to reduce taxable income, the fund uses forward contracts to offer a monthly distribution of 5¢ a unit that is treated as a capital gain instead of as a dividend.

AGF Global Balanced High Income Fund will be 60% invested in global equities, 40% in bonds.

Highstreet — acquired by AGF in 2006 — had $5.4 billion in assets under management as of Dec. 31, 2007. Its track record has attracted the attention of institutional clients, including one of the world’s largest government funds and one of Europe’s largest insurers. Highstreet also acts as money manager for pension plans, corporate investors, foundations and high net-worth families. Highstreet is 20%-owned by its management team.

Ambrosie is not concerned with launching funds amidst the most volatile market in five years. “We’ve done our homework,” he says. “We know that advisors will respond well to this in the long term.” IE