Easy Indexing By Hendrik Schwarz

Easy Indexing Buy low and sell high

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Easy Indexing Buy low and sell high

Abstract In this paper, a rule-based strategy that systematically identifies attractive stock markets is examined. Markets are ranked on a relative value basis and targeted investments in the three most attractive stock markets are made. When relative valuations change the strategy switches to more attractive indices. By including a 200-day Moving Average as a Trend Indicator, the strategy is able to adapt to a change in the market environment. The basic strategy set-up works according to the fundamental principle: invest in the three most attractive indices of your universe according to traditional value ratios. Respectively, switch to new attractive indices when relative valuations change. When more than 50% of the investment universe break their 200-day Moving Average, a change in market environment must be in place. As a consequence, the strategy switches to a long/short approach: short only the three least attractive markets on a relative value basis. A targeted short in the most expensive markets profits from a bear market. The strategy turns bullish again, and invests in the three most attractive indices of the investment universe, when more than 50% of the 200-day Moving Averages cross the underlying indices from below. A combination of Behavioural Finance approaches, as well as structural construction inefficiencies of major country indices, allow the strategies to consistently outperform its benchmark.

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Behavioural Finance – A Paradigm Shift in Financial Academia Human behaviour has always had a role in financial markets. Yet, it is only in the last years that the study of human behaviour has achieved acceptance as a distinct academic field in finance 1 . Behavioural Finance, Behavioural Economics or Open-minded Finance 2 are just a few of the many names of the search to identify the habitual cognitive errors of investors and their effects on financial markets. The Nobel Prize in economics in 2002 went to a psychologist, Daniel Kahneman, who helped pioneer the field of Behavioural Finance 3 . Kahneman basically shows that investors are predictably irrational. Investors continue to make the same mistakes over and over. Understanding the habitual and often predictable errors of human beings is both the pith of Behavioural Finance and the optimum research modality for understanding the market and profiting from it.

Behavioural Finance on the Level of the Individual Both an enormous amount of evidence and anecdotal experience suggests that people are very bad at predicting the markets 4 . This is often because we all tend to be massively overconfident. The two most common biases are “Over-optimism” and “Overconfidence” 5 . Perhaps Over-optimism is the best comprehensible of all psychological errors. People tend to exaggerate their own abilities. Overconfidence refers to a situation whereby people are surprised more often than they expect to be. Effectively people are generally much too sure about their ability to predict. This tendency is particularly pronounced amongst experts. That is to say, experts are more overconfident than lay people. This is consistent with the illusion of knowledge driving overconfidence. Several studies confirm professional investors to be particularly overconfident 6 . For instance, one study found that 68% of analysts thought they were above average at forecasting earnings; 75% of fund managers think they are above average at their jobs. In fact the appalling performance statistics of the active fund management industry tell a different story, with an average of between 75 and 90% of fund managers underperforming a benchmark index 7 . 1

There were many pioneers before that such as Granger and Morgenstern (1970) Thaler (1993) 3 It is also thanks to the efforts of economists and psychologists such as Amos Tversky, Richard Thaler, Meir Statman and Hersh Shefrin. 4 DeBondt and Thaler (1985 and 1987), Schachter et al. (1986) 5 DeBondt and Thaler (1990 6 Montier (2002) 7 A large body of empirical work, starting with Jensen (1969), finds that actively managed funds, on average, underperform the market index. 2

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However there are plenty of investment strategies that don't need forecasts as inputs such as value strategies based on trailing earnings, or momentum strategies 8 based on past prices. Easy Indexing is one of them.

Behavioural Finance on the Aggregate Level According to Kahneman and Tversky the “Availability Bias” is a rule of thumb by which decision makers reassess the frequency of class or the probability of an event by the ease with which instances or occurrences can be brought to mind 9 . All else being equal, it isn't a bad rule of thumb - common events come to mind easier than rare events. People are exceptionally afraid of financial situations involving ambiguity 10 . This translates into extreme caution on the part of investors with regard to stocks they think they don't know. The flip side of the bias is a preference for the known or the familiar or the “Home Bias” leading to investments in the local investors market 11 . However empirical studies 12 show a significant risk reduction by considering markets on a global perspective.

Buy low and sell high Price-earnings ratio (P/E) tests indicate that low P/E ratio stocks experienced superior results relative to the market, while high P/E ratio stocks have significantly inferior results 13 . The size effect indicates that small firms consistently experienced significantly larger risk-adjusted returns than larger firms 14 . This is called the “Small Firm Effect”. Tests of the small firm effect also found that firms that have only a small number of analysts following them (thus, they are neglected firms) have abnormally high returns. These excess returns appear to be caused by the lack of institutional interest in the firms. The “Neglected Firm Effect” applies to all sizes of firms 15 . A huge Eurostoxx 50 company is usually widely followed by market participants while some index members of the Danish OMX Index are hardly in the spotlight. Easy Indexing profits from the market inefficiencies mentioned above. Easy Indexing does not rely on the experience of a seasoned market pro. Neither Overconfidence nor Home Bias hinders the performance of Easy Indexing. An unemotional P/E ratio based trading signal could be blind to any market fads 16 . Easy Indexing supports the financial community P/E ratio debate arguing for predictive power of the P/E ratio.

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Kaufman (1998a), Jegadeesh and Titman (2005) Kahneman and Tversky (1973) 10 Benartzi (2001) 11 Kenneth Froot et al. (1999) 12 Dimson et al. (2002) 13 DeBondt and Thaler (1985 and 1987), Keppler (1991), Lakonishok et al. (1993), Schachter et al. (1985 and 1986), Shleifer (1998), Hong and Stein (1999), Cutler et al. (1989), O’Shaughnessy (2005a) 14 Keim (1983) 15 Elfakhani and Zaher (1998) 16 Although one could argue that the P/E ratio is mostly driven by price changes or in other words market fads. 9

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Indexation & Allocation of Capital The phenomenon of indexing portfolios to capture efficiently and cheaply the long-term return of the stock market is gathering momentum. However there is a significant underperformance against the index by many professional money managers. The consensus for indexing portfolios is that an indexed fund owns a diversified strategy. In fact most major country indices are very concentrated amongst a few sectors and stocks and do not offer appropriate diversification. As of June 21st 2006, the financial sector represents 33 % of the European Eurostoxx 50 index. For an investor it is extremely unwise to invest one third of the money that he has allocated for Europe in one sector. Another example: the 15 biggest stocks in the UK stock market (FTSE 100) represent 58% of the index. By buying the UK FTSE 100 index, an investor is buying a concentrated portfolio of big stocks. And since this movement towards big market capitalisations has taken place all over the world, a major country index will be overweight in "big caps". Still one has to keep in mind, not all country indices are structurally flawed Capital Weighted indices but the majority of them are. Easy Indexing uses the 16 largest and most liquid Western European indices as an investment universe. The total sum of 16 indices are 650 stocks, i.e. an investment in the three “smallest by number of members” Western European indices still represents a portfolio of 59 stocks, while an investment in the three “largest by number of members” Western European indices represents a portfolio of 215 stocks, a much better diversified portfolio.

How do you make money in financial markets 17 ? The money management community is using mainly three techniques to reach investment decisions: 1. Momentum Based Strategies: one of the best ways to make money in the financial markets is to identify a trend and get in (and out) at the right time. Most money managers try to invest following momentum. 2. Return to the Mean Strategies: the second way to make money in the financial markets is to buy what is undervalued/oversold and to sell what is overvalued/overbought and wait for the asset price in question to return to its historical mean. This is the strategy adopted by most “value” managers. 3. Carry Trade Strategies: the third and final way to make money in the financial markets is to play intelligently the yield curve (i.e. borrow at low rates and lend at higher rates).

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Gave et al. (2005)

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A combination of two empirical supported strategies Empirical studies 18 have shown that undervalued stocks outperform their overvalued peers. Buy stocks that are out of favour and sell them when they are back en vogue. What works for stocks, should also work for indices: just buying the index can be a cost cautious but efficient investment strategy. Due to the principle of Mean Reversion, inexpensive indices achieve an above-average performance over the long term. Therefore, a successful strategy should invest in only most attractive indices according to traditional value ratios. Then switch to the new attractive indices when relative valuations change.

How does it work? Easy Indexing is a simple 19 , rule-based strategy that systematically identifies attractive stock markets. With Easy Indexing, the 16 largest and most liquid Western European markets are analyzed according to two traditional value ratios only: P/E and P/BV 20 . The markets are ranked on a relative basis, and targeted investments in the three most attractive stock markets are made. Easy Indexing switches to new attractive indices when relative valuations change. The Easy Indexing strategy was implemented to a set of 16 Western European Country Indices. The indices used are shown in Table 1:

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DeBondt and Thaler (1985 and 1987), Keppler (1991), Lakonishok et al. (1993), Schachter et al. (1985 and 1986), Shleifer (1998), Hong and Stein (1999), Cutler et al. (1989), O’Shaughnessy (2005b) 19 Gigerenzer & Goldstein (1996), Czerlinski et al. (1999) 20 Using 12 months-Trailing Multiples of MSCI Country Indices

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Table 1: 16 Western European Country Indices Country Index Name Bloomberg Ticker 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16

United Kingdom Switzerland Sweden Spain Portugal Norway Netherlands Italy Ireland Greece Germany France Finland Denmark Belgium Austria

FTSE 100 Swiss Market Index OMX Stockholm IBEX 35 Lisbon PSI-20 Oslo OBX Amsterdam - AEX Milan – MIB30 Irish Stock Exchange Athens General DAX CAC 40 OMX Helsinki OMX Copenhagen Brussels – BEL 20 Vienna – ATX

ukx index smi index omx index ibex index psi20 index obx index aex index mib30 index iseq index ase index dax index cac index hex index kfx index bel20 index atx index

Number of Index Members

Type of Index

101 27 30 35 20 25 24 30 54 60 30 39 25 20 19 20

Capitalization -Weighted 21 Capitalization -Weighted Capitalization -Weighted Capitalization -Weighted Capitalization -Weighted Capitalization -Weighted TR 22 Capitalization -Weighted Capitalization -Weighted Capitalization -Weighted Capitalization -Weighted Total Return Index 23 Modified Capitalization Weighted 24 Capitalization -Weighted Capitalization -Weighted Modified Capitalization Weighted Capitalization -Weighted

Historical Simulations The Easy Indexing strategy was simulated from January 1994 until February 2006, with the strategy’s decision rule applied on a monthly basis. Even profitable trading strategies could lose money when commissions and slippage are added, therefore all simulations were conducted including 1.5% management fee and 5 bps per trade:

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A Capitalization Weighted Index measures the change in the market value of the index components. In this type of index the sum of all market values (market value = price*outstanding shares) is divided by the index divisor. 22 Note that effective April 21st 2006, OBX Stock Index became a total return index and had price history split by a factor of 4. 23 A Total Return Index reflects the total value of a stock portfolio in the index because it incorporates the dividends paid by index constituents as part of the calculation process. Total Return Indices are dayend only and are calculated after dividends for the constituent stocks have been analyzed after the close of trade. 24 In a Modified Capitalization Index, the weightings of large index members are capped in order to reduce the impact on the index performance by a small number of large capitalization stocks. The constituent stocks in this index are weighted according to the total market value of their outstanding shares. In this way, the impact of a component’s price change on the Index is generally proportional to the issue’s total market value. The Index value is calculated by summing up the weight-adjusted market capitalizations for all constituent stocks and dividing that sum by a predetermined base value. The value of the Index is adjusted to reflect changes in capitalization resulting from mergers, acquisitions, stock rights, substitutions and other capital events.

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Assuming a 3-year holding period for the investment, Easy Indexing would have outperformed the Eurostoxx 50 25 in 70.3% of all observations. Average outperformance against the Eurostoxx would have been 6.24% p.a. based on the Internal Rate of Return (“IRR”) for weekly launches. Graph 1 illustrates the development of the strategy: Graph 1: Internal Rate of Return for Easy Indexing for 3-year holding period Investment Horizon: 3 Years 50%

Easy Indexing Eurostoxx 50

40%

IRR (% p.a.)

30% 20% 10% 0% 94 96 95 97 98 01 99 02 00 94 95 96 97 01 98 99 00 02 03 -10% n - Ju ln - Jul- an - Ju ln- Ju ln - Ju ln - Ju l- an - Ju ln - Ju lnn - Ju lJa Ja Ja J Ja Ja Ja J Ja Ja

-20% -30% Launch Date

Assuming a 3-year holding period for the investment, Easy Indexing (the blue squaredotted line) would have had an average standard deviation of 11.46% p.a. vs. the Eurostoxx 50 (the orange triangular-dotted line) with an average standard deviation of 19.36% p.a. based on weekly launches. Easy Indexing would have been about 40% less volatile than an Eurostoxx 50 investment. The maximum drawdown of Easy Indexing would have been -4.34% while the maximum drawdown for the Eurostoxx 50 was 28.39%. Easy Indexing would have demonstrated an improved risk/return profile compared to the Eurostoxx 50. Table 2 compares the average/maximum/minimum annualized percentage return of the strategy versus the Eurostoxx 50: Table 2: Easy Indexing vs. the Eurostoxx 50 Index for 3-year holding period

Average annualized return (%) Maximum annualized return (%) Minimum annualized return (%) Average standard deviation (%p.a.)

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Easy Indexing 15.64% 43.87% -4.34% 11.46%

Eurostoxx 50 9.40% 38.48% -28.39% 19.36%

Indices aren’t directly investible. It is assumed to use the underlying index futures which can have a slightly different performance than the spot index. Furthermore in the past some indices such as the Grecian ASE Index would have been very difficult to invest with the underlying futures when costs and liquidity would have been considered. The Eurostoxx 50 was selected due to its publicity. Benchmarks such as the MSCI Europe or the Dow Jones Europe Index have performed very similar to the Eurostoxx 50 despite the fact that these indices have more index members as the Eurostoxx 50.

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Assuming a 5-year holding period for the investment, Easy Indexing would have outperformed the Eurostoxx 50 in 70.05% of all observations. Average outperformance against the Eurostoxx would have been 6.53% p.a. based on the IRR for weekly launches. Graph 2 illustrates the development of the strategy: Graph 2: Internal Rate of Return for Easy Indexing for 5-year holding period

Investment Horizon 5 years 40%

Easy Indexing

35%

Eurostoxx 50

30% 25% IRR (% p.a.)

20% 15% 10% 5% 0% Ja n9 M 4 ay -9 4 Se p94 Ja n9 M 5 ay -9 5 Se p95 Ja n9 M 6 ay -9 6 Se p96 Ja n9 M 7 ay -9 7 Se p97 Ja n9 M 8 ay -9 8 Se p98 Ja n9 M 9 ay -9 9 Se p99 Ja n0 M 0 ay -0 Se 0 p00 Ja n01

-5%

-10% -15%

Launch Date

Assuming a 5-year holding period for the investment, Easy Indexing (the blue squaredotted line) would have had an average standard deviation of 7.65% p.a. vs. the Eurostoxx 50 (the orange triangular-dotted line) with an average standard deviation of 14.70% p.a. based on weekly launches. The maximum drawdown of Easy Indexing would have only been -0.81% while the maximum drawdown for the Eurostoxx 50 was 11.50%. Easy Indexing would have increased the average annualized return by 80% with only half of the volatility and almost no negative drawdown. Table 3 compares the average/maximum/minimum annualized percentage return of the strategy versus the Eurostoxx 50: Table 3: Easy Indexing vs. the Eurostoxx 50 Index for 5-year holding period

Average annualized return (%) Maximum annualized return (%) Minimum annualized return (%) Average standard deviation (%p.a.)

Easy Indexing 14.60% 26.27% -0.81% 7.65%

Eurostoxx 50 8.07% 33.33% -11.50% 14.70%

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Easy Indexing for all Market Environments How long can a bull market last? Markets do not always rise, so market performance is not a one-way street. Most big bear markets have taken place because of a massive misallocation of capital, the classical example being the bear markets in Asia, 1997-1998 as well as the global Internet bubble, 2000-2003 26 . Easy Indexing should be able to adapt to a change in the market environment.

How will we know we are entering a Bear Market? Stock prices move in trends. However, random fluctuations in prices mask these trends. By using Moving Averages, once can eliminate the minor blips from graphs but retain the overall long-run trend in prices 27 . Although, focussing on only one Moving Average is doomed to give false signals. However, when more than the half of all underlying equity markets turn and cross their Moving Average respectively, a change in market environment must be in place 28 . Easy Indexing Long Short can adapt to this market trend.

Buy low, sell high and identify a trend and get in (and out) at the right time Easy Indexing Long Short invests in the three most attractive indices of the index universe according to traditional value ratios. Respectively, it switches to more attractive indices when relative valuations change. A Moving Average can track a trending market, but can also generate wrong signals. However, when more than 50% of the investment universe break their 200-day Moving Average, a change in market environment must be in place. Easy Indexing Long Short switches to a long/short approach. Easy Indexing Long Short shorts only the three least attractive markets. A targeted short in the most expensive markets profits from a bear market. When more than 50% of the 200-day Moving Averages cross the underlying indices from below, Easy Indexing Long Short turns bullish again and invests in the three most attractive indices of your universe.

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Campbell and Shiller (2004), Shiller (2000) Kaufman (1998b) 28 The Dow Theory argues that related Averages discount everything and must confirm each other. For a Long/Short-signal averages must move into the same direction. One could argue that what works well for the Dow Jones Industrial and Rail averages should also work for country indices of one geographical area. 27

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Historical Simulations Easy Indexing Long Short was simulated for the period January 1994 until February 2006, with the strategy’s decision rule applied on a monthly basis. Even profitable trading strategies could lose money when commissions and slippage are added, therefore all simulations were conducted including 1.5% management fee and 5 bps per trade: Assuming a 3-year holding period for the investment, Easy Indexing Long Short would have outperformed the Eurostoxx 50 in 63.6% of all observations. Average outperformance against the Eurostoxx would have been 9.81% p.a. based on the IRR for launches occurring every 2 weeks. Graph 3 illustrates the development of the strategy: Graph 3: Internal Rate of Return for Easy Indexing Long Short for 3-year holding period Investment Horizon: 3 Years Easy Indexing

50%

Easy Indexing Long Short 40%

Eurostoxx 50

IRR (% p.a.)

30% 20% 10% 0% Jan-94 -10%

Jan-95

Jan-96

Jan-97

Jan-98

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

-20% -30% Launch Date

Assuming a 3-year holding period for the investment, Easy Indexing Long Short (the grey diamond-dotted line) would have had an average standard deviation of 7.96% p.a. vs. the Eurostoxx 50 (the orange triangular-dotted line) with an average standard deviation of 19.36% p.a. based on weekly launches. The maximum drawdown of Easy Indexing would have been still positive with 0.33% while the maximum drawdown for the Eurostoxx 50 was -28.39%. The significant outperformance of the Eurostoxx 50 of 104% combined with no negative performance would have made Easy Indexing Long Short the superior investment approach to a long only Eurostoxx 50 investment. Table 4 compares the average/maximum/minimum annualized percentage return of the strategy versus the Eurostoxx 50: Table 4: Easy Indexing Long Short vs. the Eurostoxx 50 Index for 3-year holding period

Average annualized return (%) Maximum annualized return (%) Minimum annualized return (%) Average standard deviation (%p.a.)

Easy Indexing 19.21% 42.14% 0.33% 7.96%

Eurostoxx 50 9.40% 38.48% -28.39% 19.36%

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Assuming a 5-year holding period for the investment, Easy Indexing Long Short would have outperformed the Eurostoxx 50 in 63.63% of all observations. Average outperformance against the Eurostoxx would have been 9.42% p.a. based on the IRR for launches occurring every 2 weeks. Graph 4 illustrates the development of the strategy: Graph 4: Internal Rate of Return for Easy Indexing Long Short for 5-year holding period

Investment Horizon 5 years Easy Indexing Long-Short 40%

Easy Indexing

35%

Eurostoxx 50

30% 25% IRR (% p.a.)

20% 15% 10% 5% 0%

M

Ja n

-9 4 ay -9 4 Se p94 Ja n9 M 5 ay -9 5 Se p95 Ja n9 M 6 ay -9 6 Se p96 Ja n9 M 7 ay -9 7 Se p97 Ja n9 M 8 ay -9 8 Se p98 Ja n9 M 9 ay -9 9 Se p99 Ja n0 M 0 ay -0 0 Se p00 Ja n01

-5% -10% -15%

Launch Date

Assuming a 5-year holding period for the investment, Easy Indexing Long Short (the grey diamond-dotted line) would have had an average standard deviation of 3.35% p.a. vs. the Eurostoxx 50 (the orange triangular-dotted line) with an average standard deviation of 14.70% p.a. based on weekly launches – an impressive volatility reduction of 77%. The maximum drawdown of Easy Indexing would still have been positive with 7.47% while the maximum drawdown for the Eurostoxx 50 was -11.50%. The performance figures speak for themselves. Although the average annualized return of the 5-year holding period would have been smaller then for the 3-year holding period the risk/return profile would have been enhanced with a convincing minimum return with still only half of the volatility compared to the 3-year holding period. Table 5 compares the average/maximum/minimum annualized percentage return of the strategy versus the Eurostoxx 50: Table 5: Easy Indexing Long Short vs. the Eurostoxx 50 Index for 5-year holding period

Average annualized return (%) Maximum annualized return (%) Minimum annualized return (%) Average standard deviation (%p.a.)

Easy Indexing 17.50% 24.21% 7.47% 3.35%

Eurostoxx 50 8.07% 33.33% -11.50% 14.70%

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Comparative Performance vs. Hedge Fund Indices Hedge funds invest in a wide variety of public and private markets. However, the term “hedge fund” simply refers to investment vehicles with a similar legal structure. Consequently, generalizations about hedge funds are problematic and often contain more sensationalism than sound understanding. Inflows into hedge funds totalled over USD123 billion during 2004 29 . While increasing asset flows will dilute investor returns in many areas, the impact will differ depending on the supply/demand balance within the area in question. With barriers to entry low and investor interest high, many low-quality hedge funds have entered the business. These new launches are likely to provide disappointing results. In addition, many hedge funds charge unjustifiably high fees. Most investors would balk if one of their traditional managers asked for a 1% to 2% management fee plus 20% of profits, yet this is exactly what many so-called “hedge funds” represent: market-oriented managers charging exorbitant hedge fund fees. In comparison Easy Indexing and Easy Indexing Long Short historical simulations were conducted including management fee of just 1.5% and 5 bps per trade. Hedge fund indices provide a rough gauge of the diverse hedge fund group and its dedicated strategies, such as Merger Arbitrage or Distressed Trading. Graph 5 below shows the comparative performance of Easy Indexing (the blue squaredotted line) and Easy Indexing Long Short (the grey diamond-dotted line) versus the Eurostoxx 50(the orange triangular-dotted line), the CS Tremont Long Short Equity Index (the puce dotted line) and the CISDM Equity Long-Short Europe Index (the skyblue cross-dotted line), with the strategy’s decision rule applied on a monthly basis for an open-ended investment observed during the period January 2001 until February 2006 30 . Easy Indexing and Easy Indexing Long Short even outperform the CS Tremont Long Short Equity Index as well as the CISDM Equity Long-Short Europe Index. Taking the high hedge fund fee structure and the comparative performance chart from above into account, the results of the simple and cost conscious Easy Indexing and Easy Indexing Long Short strategies are quite staggering. Especially Easy Indexing Long Short would have beaten even Hedge Fund indices by a wide margin. While particularly skilful practitioners offer compelling value as concentrated or activist managers, many products offer nothing more than periodic exposure to market beta. Hedge fund fees are justifiable only for those managers possessing extraordinarily specialized expertise.

29 30

Fortmiller et al. (2005) The shorter observation period was due to the limited data availability of the ISDM Equity Long-Short Europe Index.

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Graph 5: Comparative Performance of Easy Indexing and Easy Indexing Long Short versus the Eurostoxx 50, the CS Tremont Long Short Equity Index and the CISDM Equity Long-Short Europe Index Easy Indexing 300

250

Comparative Performance

Easy Indexing Long Short Eurostoxx 50 CS Tremont Long Short Equity

Index Level

200 CISDM Equity Long/Short Europe Index 150

100

50

Ja n01 A pr -0 1 Ju l-0 1 O ct01 Ja n0 A 2 pr -0 2 Ju l-0 2 O ct02 Ja n0 A 3 pr -0 3 Ju l-0 3 O ct03 Ja n04 A pr -0 4 Ju l-0 4 O ct04 Ja n05 A pr -0 5 Ju l-0 5 O ct05 Ja n06

0

Summary Easy Indexing and Easy Indexing Long Short are strictly defined, scientifically proven trading strategies. Both systematic strategies incorporate psychological as well as economic reasons and have clear and objective “Buy” and “Sell” signals. Easy Indexing and Easy Indexing Long Short invest in the 16 most liquid European indices. The 16 indices offer a well diversified portfolio with an universe of 650 stocks. Hence Easy Indexing and Easy Indexing Long Short are transparent strategies using transparent index underlyings. Easy Indexing and Easy Indexing Long Short offer outperformance in rising but also in falling markets. According to historical simulations the long term outperformance of the strategies vs. EuroStoxx 50 is about 8-10% p.a. with on average only half the annual volatility of the EuroStoxx 50.

Conclusion The conclusion that can be drawn from the paper is thus fairly simple: there are simple, mechanical strategies that can give a risk/reward ratio greater than that of buying and holding the market index. The strategy can earn large returns without taking on additional risk Easy Indexing is an easy and simple to understand Trading Strategy, with superior and stable returns based on buying value. Active (buying value) and passive (just indices) fund management techniques are incorporated in one strategy. By following a set of predetermined rules for managing Easy Indexing, costs can be reduced, and on an afterfee basis Easy Indexing should have a significant advantage if it can deliver returns similar to passive index and active fund strategies. Easy Indexing was able to even outperform major hedge fund benchmarks based purely on the merits of the investment. The fact Easy Indexing can be delivered at lower cost is an added benefit. Because Easy Indexing is rules-based, it can also offer greater transparency compared with traditional hedge funds and depending on the investments they make, better levels of liquidity. 14

Easy Indexing Long Short is designed to do the following: • • • • • •

Provide diversification benefits when combined with traditional portfolio investments; Enhance liquidity and transparency compared with the average hedge fund; Elimination of single-manager risk; Ability to scale investments to a larger size due to the liquidity of the underlying assets; Provide meaningful protection in declining markets; and Enhance overall portfolio results.

Outlook Easy Indexing could become the platform for more diverse underlyings and other easy to gasp trading concepts such as: • •

Easy Indexing Emerging Markets Easy Sector Indexing

Appendix: Backtest Summary Table 6: Backtest Summary for Easy Indexing and Easy Indexing Long Short Backtesting summary* Easy Indexing Easy Indexing Long-Short** 147

147

2. # SIGNALS

63

66

3. Occurrence

42.30%

44.30%

1. # Observation points

4. AVERAGE #days between signals

68.9 (2.3months)

65.8 (2.2months)

5. Rolling backtests

launches every week

launches every 2 weeks

3-year holding period

477 products examined

238 products examined

5-year holding period

372 products examined

186 products examined

* Easy Indexing and Easy Indexing Long Short were tested over a 12-year period since 1994. **Long short with MAs was implemented using a 200-Day Moving Average and a "bear" signal was generated if more than half of the indices (i.e. 9 out of 16) had a price lower than the MA at the observation date, and vice versa for a “bull” signal.

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