Basket Case

kay, repeat after me: "Coors is to AOL as interest rates are to stock prices." No, that's not an excerpt from a College Board exam. Instead, it's a manifestation of the rocket science behind a new kind of portfolio known as an "Issue-Based Investing," or IBI, basket. And rocket science it is, too.

California-based Gazebo, Inc., chaired by former American Rocket Company executive Roy McDonald, has assembled a cadre of analysts and mathematicians to cook up investment models correlating stock price movements to events and trends in the news. The result of their labors are pairs of portfolios — bullish and bearish — bracketing 25 indexes, commodity prices, interest rates, and individual stocks.

Gazebo recently offered the curious a free peek into their 'Tracking Portfolio Pairs' through the company's Web site (www.gazebo.com). The list of 'metrics,' Gazebospeak for portfolios' underlying indicators, includes gold, oil, short- and long-term interest rates, the Nasdaq Composite Index, the Dow Jones Industrial Average, the semiconductor and biotechnology sectors, AOL Time Warner and Microsoft, and the Japanese and Mexican equity markets, to name a few.

So, what are these? Put simply, they're baskets of ten stocks optimized to appreciate as the targeted metrics rise, in the case of the bullish portfolios, or fall, in the case of the bearish portfolios.

Need an example? Suppose you fear AOL Time Warner's (AOL) headed south. Perhaps you need a hedge, but you don't have, or want, a margin or options account. Then one of your portfolio choices, by Gazebo's lights, ought to be Rocky Mountain-based brewer Coors (RKY). And, just so you don't have to quaff your brew in the dark, Gazebo's rocketeers also pepper the 'Bearish AOL' portfolio with five utilities (see Figure 1).

Figure 1

Gazebo Bearish AOL Portfolio

Stock                               Industry          Weight

NEWMONT MINING (NEM)                Gold              14.99%        

SOUTHERN CO (SO)                    Utility           14.19%        

ADOLPH COORS (RKY)                  Beverage          11.35%        

INDEPENDENT BANK (IBCP)             Bank              10.22%        

BLACK HILLS (BKH)                   Utility            8.24%        

WESTERN RESOURCES (WR)              Utility            8.24%        

SOUTH JERSEY IND (SJI)              Utility            8.24%        

FPL GROUP (FPL)                     Utility            8.24%        

GABLES RESIDENTIAL (GBP)            REIT               8.24%        

UNITEDHEALTH GROUP (UNH)            Health Care        8.05%   

Source: Gazebo, Inc. 5/17/02

And what alchemy is used to divine this basket? Multi-factor modeling, that's what. Multi-factor models, pioneered by risk management firm BARRA, Inc.(BARZ), have been employed by institutional money managers for over 25 years but are now, according to Gazebo, getting their first retail outing. "Gazebo's portfolios mark the first application of this methodology, we believe, for smaller investments," says Gazebo President Laurie Conner. "The minimum buy-in for a Gazebo basket is $2,000," she adds. 

BARRA executive Jane Hiscock confirms that, other than the Gazebo portfolios, "multiple factor models are not available to the individual retail investor."

Multi-factor analysis starts with the assumption that stock price movements are based upon three elements: systemic forces like interest rates, company-specific factors like product launches, and random trading noise. Each stock's unique "fingerprint" is an amalgam of these factors.

Gazebo's process winnows the Russell 3000 Index (RUA) on the basis of these fingerprints, gauging each stock against  the targeted metric "to find stocks," according to McDonald, "that are correlated because of some causality relationship." A list of the 100 most-highly correlated candidates is assembled, then optimized into a portfolio containing, says McDonald, "ten stocks which will, in combination, yield the best future correlation to the metric, as well as having the least amount of correlation with the systematic factors."

The objective, McDonald sums up, is "to provide a portfolio that will not be particularly sensitive to broad market movements, but will be exquisitely sensitive to the movement of the metric."

So, why does Coors end up in a portfolio keyed to AOL's downtrend? McDonald opines that Coors is a "classic value stock" that attracts investor attention when the market is retrenching. The brewery stock, he adds, "also may have certain parameters related to its interest rate sensitivity that were particularly valuable in the portfolio optimization process."

Gazebo's IBI stock baskets, first offered through  BrokerageAmerica for a flat $50 commission, join a field crowded with other recent innovations like bearish mutual funds, folios and exchange-traded funds. Gazebo executives are quick to point out the unique nature of these instruments, however. "We're the first company to offer portfolios built entirely from long equities," says Conner, "which give investors and financial professionals bullish or bearish slants on a broad array of market indicators, sectors, and individual stocks. IBI baskets offer the diversification of a mutual fund, together with the control and transparency of a portfolio of individual stocks. No embedded management fees, and no capital gains surprises."

Indeed, it's difficult to find bearish exposures in public portfolio investments nowadays. Rydex and ProFunds, for example, offer bear funds on only three metrics: the S&P 500 Index, the Nasdaq-100 Index, and the long government bond. These portfolios rely on selling futures contracts, while holding uninvested cash in short term debt instruments, to grab the tail of the bear. Such bear-baiting doesn't come cheaply, either. The average annual expense ratio for these portfolios is 1.54%.

But it's not just fund and folio sponsors that IBI portfolios challenge. IBI portfolios may end up competing with separate accounts, albeit as pre-packaged and highly focused contenders, without the usually rich capital requirement of such investments.

Gazebo's baskets could rival futures and options for the attention of hedgers and speculators, too. While the array of metrics tracked by IBI portfolios is already well-covered by derivative contracts, with the notable exception of the Nasdaq Composite Index, no special paperwork or registrations are required to trade the Gazebo versions. A Gazebo proxy for long or short oil futures positions, for example, can be undertaken without a Series 3 or a commodities account; a cash securities account is all that's needed.  IBI portfolios tracking individual stocks may offer alternatives to equity options and single-stock futures, too.

And it's here where IBI portfolios may offer a unique solution to a thorny problem facing many financial advisors. Russell Alexia, an Acument Securities principal in California, laments that he has "some clients with huge portions of their net worth in just one or two stocks acquired through employment or inheritance. These people won't reduce their concentrated holdings because of their low cost basis and resultant tax bite.

Alexia's quest for a solution to his clients' overexposure in General Electric (GE) and biotechnology stocks, now stalled at short sales and options, could end with Gazebo's bearish GE or biotechnology baskets. IBI portfolios may prove to be particularly attractive hedging alternatives for company insiders who may, under Rule 144, find their risk management choices otherwise restricted.

But do these things actually work?

The Gazebo folks certainly think so. Portfolio research and testing over the past five years indicates that they may be onto something, too. Take oil, for example. Over the five-year period ending in 2001, Brent Crude oil spot prices fell 13%. The IBI bearish oil portfolio backtested to a 133% gain, before costs, over that same period. Importantly, that gain could have been attained with about half of the volatility of oil prices (see Figures 2 and 7).

Not unexpectedly, the Gazebo bullish oil portfolio lost ground over the period, but not as much as its underlying metric. The bullish portfolio's volatility, however, actually exceeded that of crude oil prices. Gazebo's Chief Portfolio Architect, Edward Jenvey, accounts for this by saying that the Gazebo models pick "supercharged stocks — the ones that move the most with respect to the underlying metric. If we don't supercharge, we don't get the payoff function we want.

Figure 2

Complementary bullish and bearish portfolios make timing and rotational strategies also possible (matchings of bull and bear portfolio performance to intermediate and short term oil trends are depicted in Figure 3) as well as hedge fund-like short/long portfolios, or futures-style spread trades. Unlike short sale- or derivatives-based positions, though, bearish legs in IBI trades can qualify for long term tax treatment.

Figure 3

Source: Gazebo, Inc.

Those who don't regard commodity positions as tasty prospects can find finely tuned equity sector exposures on the Gazebo menu as well. Take the semiconductor segment as an example. Normally a focus too narrow for mutual funds,  semiconductor exposure is often sought through SOX (Philadelphia Stock Exchange Semiconductor Index) options. But the ten-stock IBI portfolios test out impressively against SOX's 17 issues (see Figures 4 and 7) over the past five years.  Most noteworthy, only two stocks are common to SOX and the Gazebo bullish semiconductor portfolio (see Figure 5), in spite of their near-equal performance. The bearish Gazebo portfolio, too, exhibited volatility well below the historic 50% implied volatility embedded in SOX options over the past couple of years.

Figure 4

Source: Gazebo, Inc.

Figure 5

Gazebo Semiconductor Bullish Portfolio (10 issues)

                              Issue     Weight

PRI Automation                PRIA      14.98%        

PMC-Sierra                   PMCS      13.57%        

Vitesse Semiconductor        VTSS      11.87%        

Advanced Energy Inds         AEIS      10.11%        

Kopin                         KOPN       8.32%        

Teradyne                      TER        8.30%        

Novellus Systems              NVLS       8.29%        

LTX                           LTXX       8.25%        

Semtech                       SMTC       8.25%        

Credence Systems              CMOS       8.06%   

PHLX SOX (17 issues)

Issue     Weight

KLA-Tencor                    KLAC      11.48%  

Novellus Systems              NVLS       9.75%  

Maxim Integrated Products     MXIM       9.71%  

Xilinx                        XLNX       7.78%  

Linear Technology             LLTC       7.65%  

Teradyne                      TER        6.14%  

National Semiconductor        NSM        6.38%  

Texas Instruments             TXN        6.06%  

Intel                         INTC       5.78%  

Broadcom                      BRCM       5.18%  

Applied Materials             AMAT       5.12%  

Micron Technology             MU         4.87%  

Altera Corp                   ALTR       3.83%  

Motorola                      MOT        3.12%

LSI Logic                     LSI        2.41%  

Lattice Semiconductor         LSCC       2.35%  

Advanced Micro Devices        AMD        2.39%  

Common issues (by weight):

                               Gazebo     SOX

TER                            8.30%      9.75%       

NVLS                           8.29%      7.65%        

                              16.59%     17.40%

Source: Gazebo, Inc., Philadelphia Stock Exchange 5/17/02

Hindsight, it's said, is always 20/20. But a backward glance, now and then, can also be very useful for plotting a course for the future. Take the tech bubble. Decrying the hysterical inflation in stock prices in those helium heydays was often the basis for one's marginalization, if not downright institutionalization. But, if Gazebo's multi-factor analysis plucks out extraneous factors and spurious correlations effectively, maybe Gazebo bullish portfolios can be used as contemporaneous indicators of a stock's intrinsic value. With that in mind, a look at the AOL graph (Figure 6) might have been a sobering and edifying experience for once-rabid AOL bulls.

Figure 6

Source: Gazebo, Inc.

Figure 7

Gazebo IBI Portfolios Performance (1997-2001)

p 

 Oil           Bullish       Bearish     

  (Brent Crude)     Portfolio     Portfolio

Ann Return        -2.63%         -0.84%         26.74%

Volatility        34.85%         46.79%         19.18%

r²                   -             .14            .00

β                    -             .89          1.39

α                    -             .01            .32

            Nasdaq        Bullish        Bearish     

           Composite    Portfolio      Portfolio

Ann Return        10.29%         17.29%         21.95%

Volatility        33.16%         58.87%         15.15%

r²                   -             .74            .00

β                    -            1.52          -.02

α                    -             .04            .17

 AOL          Bullish        Bearish     

                         Portfolio      Portfolio

Ann Return       264.45%         21.09%         17.27%

Volatility        61.77%         54.80%         14.40%

r²                   -             .35            .00

β                    -             .52            .00

α                    -           -1.19            .13

  Semiconductors   Bullish        Bearish     

            (SOX)        Portfolio      Portfolio

Ann Return        22.08%         23.00%         16.45%

Volatility        52.82%         63.76%         13.87%

r²                   -             .86            .00

β                    -            1.12            .01

α                    -            -.01            .11

(Source: Gazebo, Inc.)

IBI baskets seem to have a number of possible applications as portfolios themselves, as proxies for derivatives and individual stocks, and possibly as bellwethers of intrinsic values. Gazebo's quantitative engine has cranked out 25 portfolio pairs so far, and more are planned for the future. The Gazebo rocket crew seems to revel in fashioning these new portfolios, too. "We have fun at the end of the week sitting down and looking at what portfolios come out of this machine," says skipper McDonald. We can only wonder if they serve Coors at those weekly meetings.

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Brad Zigler, a founding member of the Global Association of Risk Professionals Education Committee, formerly headed marketing, education and research at the Pacific Exchange and Barclays Global Investors. He can be reached at brad_zigler@hotmail.com.