A lot has been written about the small investor’s irrational behavior. Academic studies have looked at brokerage accounts and seen evidence that small accounts chase hot mutual funds that cool off as soon as their money is put into it; that investors sell their winners too soon and hold onto their losers forever. These behaviors are familiar to all of us. This has created an industry of sentiment watchers who advise when the individual investor or newsletter writers are bullish or bearish. The idea is that insofar as the herd of small investors is betting one way, then since they are the least informed investors that is the end of that move.
In the past twenty years the mutual fund industry has grown to manage 9.6 trillion dollars, 4 trillion of which is in equity funds (as of December 2008). In that same time, pension fund managers have moved from investing mostly in bonds to allocating a higher proportion of the money they manage in stocks. So if we can find an inefficiency in their investing, it is possible to ride the wave.
Pension fund managers and mutual fund managers are measured against a benchmark, often the S&P 500. They want to do better than the benchmark but they are afraid to stray too far from it. If they do much worse, they will lose their job. So they turn their fund into a closet index fund.
At the end of the quarter, mutual fund managers report their positions. The manager has to publish its position so it would be embarrassing to hold a lot of losers and show the world, so fund managers window dress - sell their losers and buy the winners just before reporting. This leads to the following trading strategy.
Year end for mutual funds is 31 October. By then, fund managers have sold the losers in their portfolio and bought the market winners. By doing that, they have exaggerated the downward move of the losers and the upward move of the winners. You can construct a portfolio buying the biggest losers with institutional ownership on Halloween, at the same time, sell a basket of the biggest winners
