Call it the ultimate teaser rate. Five Categories, a startup investment advisory platform at 5categories.com, is offering investors free access to its quantitative strategy for as long as it is necessary to generate a return that beats the S&P 500 by at least 12 percentage points.
It sounds too good to be true, but Peter Kuperman, the company's founder and creator of the strategy, is doing what he thinks it takes to gain traction for a method that has been available for less than a year.
Even with more than a decade of back-tested performance data and an actual year-to-date return of nearly 70%, his investment suggestions may not sync with many asset allocation strategies.
But before detailing where the platform might fall short, it is worth considering how it works and where it might fit.
Mr. Kuperman, a managing member at QED Benchmark Capital Management LLC, has been managing money using the Five Categories model in a hedge fund since 2002. He launched Five Categories in May as a mass-market-business subsidiary of the QED hedge fund firm.
The quant strategy evaluates publicly traded U.S. companies based on 285 different metrics, which include everything from price-earnings ratio and dividend yield to debt levels and consensus earnings estimates. The various metrics are separated into five categories representing momentum, growth, value, risk and estimates.
Each category uses a different set of metrics to evaluate the overall universe of stocks. In the growth category, for example, there is an emphasis on cash flow and profit margins, while the risk category is measuring such issues as stock price stability and debt ratios.
On a monthly basis, the strategy identifies about 18 stocks that scored highest across the five categories; that becomes the entire portfolio for the next 30 days.
Although some stocks will keep making the cut, even for several months in a row, there is always the chance that the entire portfolio will turn over every month. “It's not day trading, but it's not long-term buy-and-hold either,” Mr. Kuperman said.
Because Five Categories is small, its trading strategies don't make much of an impact on the market. But significant turnover in a highly concentrated portfolio could present some problems if there is enough money tracking the strategy, according to Jim Kennedy, president of Marathon Capital Management LLC.
This year through Nov. 20, the portfolio was up 67.9%, compared with a 20% gain for the S&P 500.
Back-testing indicates the strategy would have beaten the index in each of the past 11 years, with margins ranging between 7 percentage points in 2006 and 182 percentage points in 1999.
The strategy's only negative year during the back-tested period was 2002, when it lost 4.9%, compared with a 23.4% loss by the S&P 500.
In August's portfolio, the most recent one that can be viewed on the website without a paid subscription, 11 of the 17 stocks posted positive returns. Among the big winners in the portfolio at that time was Drew Industries Inc. (DW), which was purchased March 30 and had gained 130.6% through the end of August.
Arvinmeritor Inc. (ARM) was added to the portfolio June 29 and gained 63% through the end of August.
The quant strategy also led to some misses in August, including one-month positions in The New York Times Co. (NYT) and Washington Post Co. (WPO), each of which fell by more than 10% in August.
Trading costs are absorbed by the investors or their financial advisers, who are responsible for executing the strategy on independent-brokerage platforms.
In some ways, the Five Categories model isn't much different from a newsletter subscription that identifies stocks to buy or sell. One major difference is that Five Categories won't charge its $100 monthly subscription fee until the strategy hits the 12-percentage-point hurdle rate.
The hurdle rate is set for each investor, beginning with the month the account is opened. To get the hurdle rate, an account must contain at least $25,000.
Five Categories is also creating an actively managed exchange-traded fund that will use a similar quant strategy but won't be as concentrated. The ETF, scheduled for an April launch, will hold between 100 and 150 positions, Mr. Kuperman said.
In the meantime, the strategy is already being used by 100 premium subscribers, while another 7,500 non-trading subscribers have signed up to monitor the portfolio.
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
