Nov. 2, 2009, 12:01 a.m. EST ·

Pay to play?

Commentary: Fund managers' incentives affect stocks they buy

By Mark Hulbert, MarketWatch

ANNANDALE, Va. (MarketWatch) -- It's somehow fitting that as traders focus their sights on November, our political leaders are focusing on compensation reform.

That's because pay incentives are also key to determining which trading strategies are likely to be most and least profitable this month.

To be sure, the pay incentives of greatest interest to traders are not those for bank CEOs, which are the focus of the current political debate. Instead, the ones most relevant to traders are those that prevail for mutual fund managers.

I concede that the relationship between November's trading strategies and fund managers' compensation is not at all obvious. But that relationship nonetheless exists, and shrewd traders may want to try exploiting it.

The key to understanding this otherwise inscrutable relationship is an appreciation of what needs to happen for a fund manager to earn a year-end bonus. In most cases, earning that bonus depends on outperforming a pre-determined benchmark, and by far the most commonly used benchmark is the S&P 500 /quotes/comstock/21z!i1:in\x (SPX 1,043, +6.69, +0.65%) .

Believe it or not, the seemingly innocuous decision of which benchmark will be used to judge their performance has profound consequences for how managers behave.

Consider first a manager who right now is ahead of the S&P 500 for year-to-date performance. Even if he is behind the Russell 2000 for year-to-date performance, this manager knows that if he can hold on to his lead above the S&P 500 for another two months -- until December 31 -- he probably will earn a decent bonus.

He thus will have an incentive to make his portfolio look more and more like the S&P 500, which will have the effect of locking in his lead. That means he will tend to be a net seller of secondary stocks that are not part of the S&P 500.

Money managers who currently are behind the S&P 500 also will have an incentive to reorient their portfolios to be more like the S&P 500. That is because their desire to take on more risks in order to possibly rise above the S&P 500 by year's end will be outweighed by the fear of losing their bets and lagging the S&P 500 by a large margin -- in which case even their jobs might be in danger.

One implication of this reduced appetite for risk as the year progresses is that the beginning of the year will be a lot different than the end of the year. That's because, once Jan. 1 rolls around, managers' compensation slates will be wiped clean. Their willingness to take risk, which often manifests as an eagerness to bet on secondary stocks, will be at the highest point it will be all year.

That in turn means that managers in January will likely be net sellers of the large caps they increasingly will be purchasing over the next several weeks, while being net purchasers of the secondary stocks that they will be selling in the near term. Because of this tendency, large caps are likely to outperform small caps in November and December, while just the reverse is likely to be the case in January. (This latter tendency, by the way, is the source of the well-known year-end seasonal pattern that is known as the January Effect.)

This isn't just theory, by the way; it has been documented by any of a number of academic studies. One that provides a good summary of the data supporting the theory was authored by two finance professors, one of whom is also an economist at the Federal Reserve Bank of Atlanta. Click here for a copy of the study.

What would a trading strategy look like that tries to exploit this tendency? A particularly aggressive one would be to simultaneously buy an exchange-trading fund that reflects the S&P 500 index (such as the SPIDERS S&P 500 /quotes/comstock/13*!spy/quotes/nls/spy (SPY 104.32, +0.76, +0.73%) ) and sell short an ETF that reflects the small-cap sector (such as the iShares ETF that is benchmarked to the S&P Small Cap 600 index /quotes/comstock/13*!ijr/quotes/nls/ijr (IJR 49.35, -0.07, -0.14%) ). Notice that such a strategy makes money regardless of whether the overall market goes up or down -- provided that the S&P 500 does better than secondary stocks.

A more conservative strategy would be to reduce your holdings of secondary stocks now and replace them with stocks that are part of the S&P 500 index. Such a strategy doesn't require selling short, though it is vulnerable to a decline in the overall market.

For those of you who are interested in such a strategy, here is a list of the stocks that currently are most recommended by those investment advisers who have beaten a buy-and-hold in the stock market over the last decade on a risk-adjusted basis. The list is in order of their popularity, with the most popular stock on top:

• AT&T Inc. /quotes/comstock/13*!t/quotes/nls/t (T 25.59, -0.08, -0.31%)

• Johnson & Johnson /quotes/comstock/13*!jnj/quotes/nls/jnj (JNJ 59.49, +0.44, +0.75%)

• Wal-Mart Stores Inc. /quotes/comstock/13*!wmt/quotes/nls/wmt (WMT 50.28, +0.60, +1.21%)

• International Business Machines /quotes/comstock/13*!ibm/quotes/nls/ibm (IBM 120.56, -0.05, -0.04%)

• Automatic Data Processing Inc. /quotes/comstock/15*!adp/quotes/nls/adp (ADP 40.44, +0.64, +1.61%)

• Abbott Labs /quotes/comstock/13*!abt/quotes/nls/abt (ABT 50.91, +0.34, +0.67%)

• Chevron Corp /quotes/comstock/13*!cvx/quotes/nls/cvx (CVX 76.64, +0.10, +0.13%)

• General Electric Co. /quotes/comstock/13*!ge/quotes/nls/ge (GE 14.47, +0.21, +1.47%)

• Hewlett Packard Co. /quotes/comstock/13*!hpq/quotes/nls/hpq (HPQ 48.16, +0.70, +1.47%)

• Lockheed Martin Corp. /quotes/comstock/13*!lmt/quotes/nls/lmt (LMT 68.87, +0.08, +0.12%)

• Microsoft Corp. /quotes/comstock/15*!msft/quotes/nls/msft (MSFT 27.88, +0.15, +0.54%)

• Unitedhealth Group Inc. /quotes/comstock/13*!unh/quotes/nls/unh (UNH 26.42, +0.47, +1.81%)

• AFLAC Inc. /quotes/comstock/13*!afl/quotes/nls/afl (AFL 41.32, -0.17, -0.41%)

• PepsiCo Inc. /quotes/comstock/13*!pep/quotes/nls/pep (PEP 60.60, +0.05, +0.08%)

• Coca-Cola Co. /quotes/comstock/13*!ko/quotes/nls/ko (KO 53.72, +0.41, +0.77%)

Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.