Death of seasonality?

16Nov05

One of our favorite topics is the role seasonality plays in the equity market. Apparently we are not alone.

ABN Amro is creating a series of indices to track the effect of seasonality on a number of national stock indices. Philip Coggan at the Financial Times reports on the launch of the ABN Amro Alpha Indices. From the ABN Amro press release:

Piero Overmars, Chief Executive of ABN AMRO’s wholesale banking business, said: “The ABN AMRO Alpha Indices will set a new benchmark for transparent, pure rules-based and professionally managed investment indices created to achieve risk-adjusted out-performance against traditional equity indices.”

This performance is achieved by taking exposure to markets during month-end and holiday periods when investors reduce risk (for example, to clean up their holdings before reporting profits & losses). At all other times, cash will be invested at money market rates.

Apparently these indices will also serve as the foundation for a series of investment products. From the FT:

The products will be in the form of certificates, which will be listed on stock exchanges, and will have total costs (including fees) of 1 per cent a year. The certificates will initially be aimed at the institutional market but ABN Amro eventually hopes to market the concept to retail investors.

A body of research has been built up that shows the efficacy of seasonality strategies. Not surprisingly ABN Amro researchers found likewise:

ABN Amro back-tested the strategy for a range of markets, dating back to 1998 (for Switzerland) to 1925 (for the Dow Jones Industrial Average). In every case, the strategy delivered higher annual returns with lower volatility, or risk. In the Netherlands, for example, the alpha index delivered annual returns of 11.9 per cent, with volatility of 11.2 per cent; the domestic AEX index returned 7.4 per cent, with volatility of 21 per cent over the same period.

The launch of the indices raises a number of questions (and concerns) for investors who currently use seasonality in their investment process:

By measuring the seasonality effect, and making it easy to implement, these indices may increase seasonality’s popularity and therefore make it less profitable over time.
It sounds like the indices ignore the “Sell in May and go away�? phenomena. The indices apparently will only take positions around holidays and month-end. This will limiti their potential profitability.
One intriguing aspect is the global nature of the indices. Investors now can more easily participate in seasonality strategies on a global basis.
The popularity of this product for the broad market is questionable. While seasonality indices may produce higher risk-adjusted returns, they will generally not produce high absolute returns without the use of leverage.

Are these indices are poorly named? The ABN Amro Alpha indices produce their returns through a systematic application of market timing. One could state that these new indices are simply a codification of an already well-known beta process. Alpha in a strict sense should measure investment skill. While seasonality may generate risk-adjusted investment profits, it is not altogether clear whether they represent true alpha.