In the Nov. 10 issue of Pensions & Investments, we explained how the Omega excess return appeared to have some predictive power. If a firm was in the top quartile in a given year, there was a 70% chance it would be in the top quartile the following year. This is surprising, but could one have made more money with this information? To answer this question, we compared the results for four strategies.
The first strategy assumes the investor chooses the fund with the highest Omega excess return at the end of each calendar year and holds that until the end of the following year. This will be referred to as the Top Omega strategy. The second strategy assumes the investor simply invests an equal amount in all of the funds and holds that portfolio. The third strategy assumes the investor chooses the top quartile of funds based on Omega excess returns. The final strategy simply selects the fund with the highest raw return at the end of each year.
The results are shown in the graph on this page, and assume no taxes and no transaction costs. Not surprisingly, the worst results were obtained by investing in the fund with the highest raw return in the previous year, i.e., the return unadjusted for risk, or anything else. This is consistent with other studies warning against buying last year's winner. Still, a cumulative return of 796%equates to a 15-year compound growth rate of 15.7% By simply holding all of the funds that were in business in 1980, and were still in business at the end of 1996, one could have increased the cumulative return to 943%
Now, let's take a close look at how the Top Omega strategy appreciated 1,444%over this period for a compound growth rate of 20% At the end of 1980, the investor would have invested in Fidelity Magellan until the end of 1986. Then, IDS New Dimension replaced Magellan, followed by Growth Fund of America, Janus, four years in Fidelity Contra fund, and two years in Keystone Small Company Growth fund. Neuberger & Berman Partners replaced Keystone for 1997.
Most of the funds that are ahead of Neuberger Berman in the current ranking on page were not in existence in 1980. Investing in last year's top Omega fund did not produce the best results in every year, and past results are no guarantee of future results. Nevertheless, the best results for the past 15 years were produced by the top Omega excess strategy, and the second best results by the top quartile of Omega excess funds.
The evidence for the past 15 years suggests the Omega excess return captured something that allowed one to capitalize on an inefficiency in the market. However, like every other means for exploiting inefficiency, it can only work so long as it is not widely used.