Guided by the market
Supply and demand key to manager's decisions
I speak to many money managers as part of my research endeavours. Most managers practice a similar style, with a slightly different twist here and there. But once in awhile, I speak with a manager that truly has an attitude and philosophy that is in the minority - at least in the mutual fund world. While I don't buy into all of the different philosophies I hear, I often find them intriguing. This week, I'll give you a glimpse into philosophy of a little-known firm from St. Catherines Ontario - Crystal Wealth.
Short- vs. long- term
I've written many times about the factors that influence long-term stock returns. Stock valuations, future interest rate changes, and future growth in cash flows capture most of the market's long-term returns. But what about the short term?
I must admit that I agree with those that attribute some of the nutty short-term movements in stock prices to investor psychology. However, the so-called "smart money" (i.e. investment bankers, brokerages, pension funds, etc.) isn't immune from this phenomenon. We needn't look any farther back than 1999 for solid proof. For instance, one tech stock that was in the $60 range fetched bullish targets from some brokers in the $80 range. Once it broke $80, the brokers' target would hit $100 - and so on.
While most money managers are focused on buying today in the hopes of realizing their target returns over the subsequent three to five years, Crystal aims to exploit the psychology-driven inefficiencies that are characteristic of daily market action. Even with the more recent fall in the volatility of stock prices, daily market movements remain significant.
Clayton Smith, lead manager of the Crystal Enhanced Index RSP fund, maintains that fear and greed drive short-term market movements. Hence, he says that market volume (i.e. the number of shares changing hands) and price changes (i.e. both direction and magnitude) combine to give him insight into the supply and demand for stocks - and hence the direction of the market.
His logic has intuitive appeal since prices do rise when there are more buyers than sellers, and vice versa. However, in order for this information to be exploited for profit, investor demand for stocks must have some predictable staying power.
Smith's philosophy is based on the assumption that the supply and demand for stocks is somewhat persistent. In other words, he believes that strong demand for stocks (i.e. strong upward movement with lots of shares changing hands) one day will likely persist long enough for him to jump on the market's coattails.
Conversely, he says the same persistence holds on the downside - which, in theory, would allow him to jump out of the market allowing him to avoid much of the downside.
His conclusions are the result of proprietary market research and analysis. While advising individual clients several years ago, Smith says he spent most of his time on research. The relationship between investor demand and subsequent returns was an early belief that he began researching using technical analysis.
(Technical analysis focuses on patterns of market movement that repeat over time. Fundamental analysis is the more common method of researching companies to find stocks trading at reasonable values.)
In practice, Smith makes one decision daily. Based on the market movement and volume on the previous day, he decides whether or not to be in the market the following day. Hence, if the market shows strong downward momentum one day, the Crystal funds will happily sit in cash the next day.
Crystal Enhanced Index RSP is either in S&P 500 futures contracts or it's in cash - and it's an all or nothing decision. Its use of instruments means the fund is best suited for a tax-deferred account - i.e. RRSP, RRIF, etc. - given the taxable income that typically flows from funds using derivatives.
In addition to a base management fee of 1.75 per cent annually, the fund charges a performance fee equal to fifteen per cent of the amount by which it outperforms the S&P 500.
The fund was launched in the summer of 1999, so its history is brief. However, that's an interesting period because it includes nearly a full year of strong index returns along with a significant market decline and the most significant terrorist attack in North American history.
During the nearly three-year period, the Crystal Enhanced Index RSP has the following stats:
So far, Smith has been successful and he is so confident in his model that all of the firm's employees have all of their investment assets in the fund.
While Smith expects to move from futures to cash, or vice versa, every few days, the fund's return patterns indicate that it has had exposure to the market roughly 70 per cent of the time. In that context, its positive return of nearly three per cent annually is a significant accomplishment during a period that was witness to an annualized loss of more than six per cent for the index.
While those of us that subscribe to fundamental analysis used to equate technical analysis with voodoo, the academic world has begun to embrace the potential of technical indicators. James A. Bennett and Richard W. Sias published an article in the November/December 2001 issue of the Financial Analysts Journal entitled Can Money Flows Predict Stock Returns? They studied 86 million U.S. stock trades (rather than the index) but their findings parallel Smith's beliefs.
In short, Bennett and Sias noted the following conclusions:
While I wouldn't consider myself a convert just yet, I am intrigued by the performance of the fund in its brief history and the research supporting its strategy.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at email@example.com
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