Stocks on the Move: Beating the Market with Hedge Fund Momentum Strategies by Andreas Clenow

The Problem with Mutual Funds
Almost everyone in the developed world has an ownership stake in a
mutual fund. Even if you didn’t actively buy into any mutual fund, your
pension fund is most likely invested in some of these vehicles. Mutual
funds seem like a logical solution and they have been hailed by
governments, universities and banks as the perfect solution for individuals
to participate in the equity markets.
Before you buy into a mutual fund, you should be fully aware of what it
really is and how it works. Most people are not familiar with what a mutual
fund tries to achieve and how it goes about it. Even more importantly, you
should be familiar with how mutual funds have performed in the past. After
all, asset management is a highly measurable business and it’s quite easy to
compare and analyze how investment products actually performed.
While the idea of collective investment schemes is quite old, the mutual
fund industry as we know it has only been around since the 80’s. The
overall idea is to allow for anyone to participate in the general stock market,
even with smaller amounts in the simplest possible way. Of course you
could participate in the markets by simply buying a basket of stocks, but
you’d quickly realize a few practical problems with that. If you’re looking
at an index such as the S&P 500, like the return and would like to replicate
it, you’d have to buy into 500 stock positions. Well, some have such small
weights in the index that you could probably get a close enough replication
by just buying half of the 500 member stocks. But you’d have to keep track
of the weights and the membership changes and actively manage your
portfolio to match the index. If you don’t, you wouldn’t get the same return
as the index. Perhaps more, perhaps less, but not the same.
And what if you would like to invest $100 a month for long term saving? It
wouldn’t be possible as you can’t buy fractions of a share. Even if you want
to follow the Dow Jones Industrial Average with only 30 stocks, you can’t
buy them with for such small amounts. Even if you could, you’d have to
handle weight rebalances and all the other hassle that most people simple
don’t want to do, and would not be able to do.
Enter mutual funds, the savior of the poor people and the democratizer of
financial markets. Each fund aims to follow a specific and predefined index,
and as a small investor you can simply place your $100 with the fund and it
will be pooled with everyone else’s money and invested to replicate the
index. Almost.
As the mutual fund is measured against a specific index, they are relative
investments. This means that their job is not to make money for their
investors. Go on, read that last sentence one more time. A mutual fund is
tasked with attempting to beat a specific index. If that index loses money,
the job of the mutual fund manager is to lose slightly less money than the
index. In a bull market, his job is to make slightly more than the index. So
far fair enough, as long as you’re aware of this.
A core concept in mutual fund world is tracking error budget. It’s not like a
mutual fund manager can do whatever he likes to beat the index. Far from
it. Tracking error is a measurement of how much the returns of a fund is
deviating from the index. The daily returns for the fund are measured
against the daily returns of the index. The allowed tracking error, or
tracking error budget, is normally very small. The fund simply is not
allowed to deviate much from the index.
Mutually Assured Destruction
What a mutual fund actually does is to take almost all the money in the fund
and allocate it in-line with the index. If a stock has a weight of 5.2% in the
index, you buy somewhere between 5% and 5.4%. There’s very little
leeway for the mutual fund manager to impose his or his bank’s investment
views. They can at times make slightly larger deviations from the index, but
bear in mind that this can be very dangerous.
There’s an old expression in the business that governs much institutional
investment behavior. “No one ever got fired for buying IBM.” What this
means is, that if you do what everyone else did, you don’t risk anything

Stocks on the Move: Beating the Market with Hedge Fund Momentum Strategies by Andreas Clenow