You Can’t Win This Game, So Don’t Play It
Most investors have heard of the “Santa Claus rally.”
This December tradition takes place between Christmas and New Year’s, when stock prices can seem to climb for no reason at all.
But the biggest pops in many popular stocks seem to always happen on the last trading day of the year.
While it may be tempting to buy into the frenzy, my advice is simple: don’t.
The run-up is most likely the result of a game institutional money managers play each year to inflate their pay. And you can’t win it.
‘Tis the Season
The game I’m talking about is one Wall Street traders call “marking the close.” Others call it “window dressing.”
It’s a practice in which institutional, hedge fund and mutual fund managers buy up shares of stocks they already own during the final trading day of the year.
Doing so allows them to make their performance look better than it was. It’s a strategy they use to pad their year-end results – and their paychecks.
After all, performance fees are the most lucrative component of an asset manager’s compensation.
And higher stock prices at the close of the year mean higher fees for the manager, regardless of where the stocks trade come January. (More often than not, shares will trade back down to where they started… or lower.)
The compensation structure favored by institutions is called “2 and 20.”
Each year, managers receive a 2% “management fee” – even when they lose money. Investors pay them 2% of the money they have invested with the manager each year.
For example, the management fee on a $1 million investment would be $20,000.
But the big money is made in “performance fees”…
The managers get 20% of the fund’s annual gains. So if a $100 million fund is up 20% for the year, the manager takes home $2 million.
If the fund is up 25% come year end, the manager will take home even more – $2.5 million. In this case, every percentage point gain a manager books puts another $100,000 in his pocket.
That’s why it isn’t uncommon to see moves of 5% or more in stocks being window dressed, especially in late December. And you’ll see even higher moves in stocks with low trading volumes.
So when an asset manager does this to a large number of the positions in his portfolio, it’s not hard to boost the fund’s returns by 2% to 5%. Think of it as portfolio pumping.
Buyers Dry Up in January
Of course, the problem for investors who unknowingly buy into the portfolio pump is that those gains will disappear as soon as the next year begins… because, by then, no one is around to pay up for the stock.
But professional money managers don’t care. They already were paid.
At that point, they have an entire year to make up for the loss. Some may even sell the newly minted loser and buy an entirely different stock.
This is the portfolio dumping. And it leaves the long-term investor owning a stock deep in the hole.
So if a stock you’ve been eying makes a big run on no news… be wary about buying into it as 2016 ends. That way, you won’t help pay for those institutional bonuses.
Remember, when a stock price increase seems too good to be true… it usually is.