Beyond The Abstract: Getting Started

January 28, 2008

A look at some of the latest research ...

As a recovering English Literature major (yes, like reformed addicts, we are always recovering), it seems logical that I should tackle the job of reviewing research for IndexUniverse.com. After all, what better way to learn than by reading research conducted and written up by experts?

Not surprisingly, I'm starting off pretty basic. While I understand indexes pretty well, the investment strategy part of it is something I'm far less comfortable with—once it goes beyond basic index investing, that is. You might say I understand indexes perfectly in the abstract or in a vacuum, but for indexes to be useful to investors, you need to see where they fit in the real investment world.

Murray Coleman already took "The Long Road" as the name for his column, which would have been perfect for MY column since I will obviously be on a long road to enlightenment, but Murray thought of it first. So I'm making do ... and shooting Murray some dirty looks through my computer screen.

The working title for my column is currently "Beyond the Abstract." Get it? I hope to go beyond abstract imagery to practical examples and because I'm going to look beyond the abstract that's at the front of every research report. (See, it's kind of like a play on words ... never mind!) 

In any case, "Beyond the Vacuum" just does not have that ring to it—it sounds like an advanced guide to household cleaning, and anyone who's seen my home knows I shouldn't be writing one of those.

For the first batch, I'm going to look at some of the free research papers posted on the SSRN Web site, because, well, free stuff is pretty cool. This week we feature the simple, the complex and the truly weird.

The Simple: A Primer On 130/30 Funds

One article struck me because of its relevance, although it was first published in October 2007. In "130/30 Funds: What Is Behind The Commercial Offensive," Walter Gehin, a research associate at EDHEC Risk and Asset Management Research Centre and a business analyst with Atos Euronext Market Solutions, offers a sort of primer on 130/30 funds, or rather 1X0/X0 as Gehin calls them, since they could just as easily be 140/40 funds or 110/10 funds. These funds follow a strategy in which they invest in 100% of an index, but short X0% of the index and use the proceeds to buy another X0% of the index that is likely to outperform. The strategy is fairly popular, with asset inflows into these funds increasing exponentially in recent months, and Standard & Poor's not too long ago launched an S&P 500 130/30 fund that offers the first benchmark for the strategy itself.

At 10 pages, the report is a sort of quick-and-dirty guide to 1X0/X0 funds that offers an introduction to the key points to consider about the strategy—perfect for the investor looking to see what all the fuss is about. It takes a look at the theory behind the strategy, the implications of different levels of shorting, the quantitative versus fundamental dilemma, the similarities and differences between long only and 1X0/X0 strategies, and the importance of understanding the levels of risk associated with 1X0/X0 strategies. In doing so, the report offers a perspective on the strengths and weaknesses of the strategy that investors that are new to the concept may lose sight of. While some parts of the report seem like common sense ("Gee, should I really look at the fund manager's level of experience in shorting when investing in a fund in which shorting is a crucial part of the underlying strategy?"), it raises some points to consider that someone new to the 1X0/X0 concept may not immediately hit upon.

The Complex: Liquidity And Returns

The report titled "Trading Volume Liquidity And Investment Styles" by Jeffrey H. Brown and Douglas K. Crocker of Highstreet Asset Management Inc. and Stephen R. Foerster of Ivey Business School, University of Western Ontario, looks at the relationship between liquidity and returns according to three different factors—trailing three-month trading volume, dollar value of trading volume, and turnover—using the stocks in the S&P 500 and an index very similar to the Russell 1000. It also relates returns and liquidity levels to investment style and size segment.


Basically, what this report's primary finding seems to be is that higher liquidity means more extreme returns. Stocks with higher liquidity as determined by trading volume and turnover tend to have higher returns, while those with higher liquidity as determined by dollar value tend to have lower returns.

From there, the study focuses on trading volume as it relates to stock performance within different types of stocks. The results imply that growth stocks have higher volumes than value stocks, and large stocks have higher volumes than small stocks. Stocks that have been at the extreme ends of the returns spectrum also seem to have high trading volumes. As a result, the study concludes that liquidity should be of great concern for small-cap and value managers, but not necessarily for momentum managers.

There's a lot more to it than this. The report describes the methodology of the study in depth, but these seem to be the raw findings.

The Weird: S&P 500 Returns And Kids

And now we've come to the bizarre segment of our column. Ivan Kitov of the Russian Academy of Sciences - Institute for the Geospheres Dynamics, and Oleg Kitov of the University of Warwick in the U.K., have conducted a study that says the returns of the S&P 500 can be predicted accurately by the population level of 9-year-olds in the United States. The report is titled "Exact Prediction of S&P 500 Returns."

To the rational mind, the first thing that leaps to the forefront is "DATA MINING." Look at enough number series and eventually you're going to run into some chance correlations. Is that the case here? I'm inclined to say yes, but take a look for yourself ...

The premise is that population change affects economic growth, and it's just a matter of finding the right age group (what the authors call the "specific age") to link it to for the country in question. For the U.S. and the U.K., that would be the age of 9 (for other European countries and Japan, the report says that age is 18). The conclusion argues that based on the data, accurate predictions of annual S&P 500 performance can be made up to nine years in advance, with accuracy depending largely on how accurate the census of 9-year-olds is. The authors state that 2007-2010 will be a critical time for the theory—and the data seems to indicate a sizable jump ahead for the index in 2008 followed by what the authors describe as a "catastrophic fall." Figures 10 and 12 are perhaps the most interesting as far as demonstrating the article's claims. It should be noted that the market decline in November appears to have been accurately predicted by the model.

I'm curious about why 9-year-olds are the defining age group. Are they really the force driving our economy? My younger cousins at 9 were interested primarily in McDonald's, Legos, video games and soccer. This is hardly the stuff that moves markets. Or are there clandestine cabals of pre-adolescents secretly making the business decisions for our leading corporations? Any theories would be welcome.

FYI, Portfolio.com's Zubin Jelveh has discussed the report on his "Odd Numbers" blog as well.

Until Next Week ...

So there you have it: the simple, the complex and the just plain weird. If you have any research or articles you think would be interesting to pass on, please feel free to let me know.

Heather Bell is assistant editor of IndexUniverse.com. She can be contacted at [email protected].

 

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