The little index that beats the markets

Successful investors used to be happy just to be rich. Then, when investing went mass market in the 1980s, they weren't satisfied unless they were dispensing advice in books, newspapers and on television. Nowadays there's another string to their bows: endorsing their own quant index.

Joel Greenblatt, author of The Little Book That Beats the Markets and managing partner of Gotham Capital, is the latest to enter the fray with his Gotham Enhanced Value Index Series -- a quant strategy designed by Royal Bank of Scotland's equity derivatives team that replicates the "magic formula" outlined in his little book.

On the face of it, Greenblatt's formula is not a difficult one to understand or to replicate as it involves just two inputs: earnings yield and return on capital, which Greenblatt uses to identify good companies that are trading at bargain-basement prices.

"Buying businesses with above average returns on capital at below average prices when they are undervalued by the market is the overwhelming logic behind the ratios," explains the index brochure. "Over time, these undervalued shares should tend towards the mean, ie appreciate in price as their value is recognised by the market."

It clearly worked for Greenblatt, who set up his hedge fund in 1985 with money from Michael Milken and earned more than 50% returns (annualised) during the next 10 years -- the kind of pay-off that he says anyone can earn, so long as they "really, truly believe" in his magic formula.

But there's a catch. "The formula used in The Little Book That Beats the Market is designed to be understood and applied by everyone. However, it requires the discipline to be applied consistently and the patience to hold the methodology even during periods of underperformance. Further, investors may not always have access to high quality information on companies, and may be using different accounting approaches and conventions."

In other words, unless you're a professional with a firm of analysts working for you, it's tricky to replicate Greenblatt's performance. But not anymore. Now, investors can throw away their copy of the book and simply buy his index instead.

Starting with a universe of liquid US stocks issued by large companies, the strategy calculates a rank for each one based on their pre-tax operating yield and their return on capital employed. Certain sectors, such as financials, including real estate and insurance, and utilities are excluded, because the magic formula doesn't really work on them. (American utilities companies, for example, pay a regulated return to shareholders and are therefore not directly comparable to businesses that pay a market rate of return, while the balance sheets of financials simply defy analysis, as everyone now knows.)

Next, the strategy works out a combined ranking and invests in the top 25 stocks. Its three biggest holdings at the moment are Pfizer, Lockheed Martin and Accenture.

Running the model against historic price movements for the past 10 years shows an impressive 18.7% annualised return, compared to a loss of 0.8% for the S&P 500 -- though a decade is a short period over which to judge a long-term strategy such as Greenblatt's.

By the same token, it would also be unfair to judge the magic formula based on its short-term performance, which is lucky. Validea, a website that builds model portfolios based on the strategies of 10 famous stock pickers, first launched a similar Greenblatt model in early 2006, during which time the 20-stock basket has returned an annualised 1.4% -- which means he's tied with Warren Buffet for last place -- with a stock-picking accuracy of 50.3%.

But now could be a good time to buy, according to RBS. "As stock markets are showing signs of gradual recovery, investors are looking for non-speculative exposure to equities with long-term growth potential," said Matthew Wong, the bank's head of equity derivatives and private investor product sales for Asia. "The GEVI series offers investors a robust and transparent investment tool for generating exceptional simulated performance through value investing strategy."

Validea's Greenblatt strategy has recovered well this year, with a 50% return that ranks him third, behind the legendary Peter Lynch and the accountant-turned-investor Joseph Piotroski.

This index will be followed by a global version that aims to give exposure to shares in the Americas, Europe, Asia and Australia, and a worldwide ex-US version.

Rumours of a Greenblatt's Magic Formula perfume are unfounded, according to market insiders.