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Stock-Market Brainiac Starts Hedge Fund

Equity guru Roger Ibbotson has opened a hedge fund, and two mutual funds based on new research.

NEW YORK (TheStreet) -- Roger Ibbotson, founder of Ibbotson Associates, has influenced how millions of investors think. Ibbotson Associates, which was bought by fund-research firm Morningstar, gained prominence by publishing data on how stocks have outpaced bonds over long periods. That has led many investors to overweight stocks.

Now Ibbotson, a professor of finance at Yale who received a doctorate at the University of Chicago, has begun a hedge fund called

Zebra Global Liquidity Arbitrage Fund

. The fund is based on his latest research on stock performance. Ibbotson has high hopes that the new investing strategy will prove widely influential.

The fund focuses on the trading volumes of stocks. The idea is that stocks with low trading volumes tend to outperform those that trade many shares a day. "Stocks with high trading volumes tend to be the glamour companies that get overpriced," says Ibbotson. "Stocks with low volumes are not in the news, and they tend to sell at discounts."

To design his approach, Ibbotson looked at how a variety of strategies would have performed during the 34 years ending in 2005. He found that simply buying stocks with high trading volumes would have returned 9.4% annually, compared to 11.3% for the

S&P 500

. Stocks with low volumes outdid the benchmark by half a percentage point.

In his back-testing, Ibbotson looked at a variety of different strategies. Among the worst performers were stocks with high volumes and low earnings. He found that the best-performing combination was stocks with low trading volumes and high earnings, which returned 15.1% annually.

For the fund, he uses about half the assets to buy shares with low volumes and high earnings. The rest of the fund goes to short stocks with high trading volumes and low earnings. "We are shorting hot stocks that are fundamentally weak," he says.

To size up a stock, Ibbotson calculates its ratio of trading volume to earnings. He calls this the V-E ratio. The earnings are figured based on a formula that considers total current earnings and Wall Street's forecasts of future results. Stocks with the lowest ratios become long positions in the fund.

In some respects, Ibbotson's low-volume stocks resemble the kind of names that appeal to traditional value investors. But he argues that the new approach can provide better results than simply taking stocks with low price-earnings ratios. "Less liquid value stocks will have higher returns than more liquid value stocks," he says.

For years now, researchers have known that small stocks tend to outperform large ones, and value stocks beat growth. Many funds have been based on those findings. Now Ibbotson believes that investors will begin focusing on his research, emphasizing stocks with low trading volumes.

The minimum initial investment in the hedge fund is $1 million. For those with smaller budgets, Ibbotson has also introduced two retail mutual funds,

American Beacon Zebra Large Cap Equity


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American Beacon Zebra Small Cap Equity

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. The mutual funds take long positions in low-volume stocks and don't take short positions.

Because the hedge fund sells short, it should outperform the mutual funds in downturns, says Ibbotson. He says that, in back-tests, the hedge fund has outpaced the mutual funds over long periods with lower volatility. But the mutual fund should also be relatively tame, says Ibbotson. He figures that the mutual fund should have a beta of 0.75. So if the S&P drops 10%, the mutual fund should only fall about 7.5%. The hedge fund is market neutral with a beta of 0, suggesting it won't track the broader market.

Ibbotson says the stocks in his portfolios tend to be steady performers that cause little excitement. A holding in the large-cap mutual fund is

Precision Castparts


, a maker of components for gas turbines and jet engines. The company has fat profit margins. "This is a big company, but nobody has heard of it because they make parts that are used by other manufacturers," says Ibbotson.

Other steady earners in the portfolio are

Time Warner Cable




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, operator of the Bell Canada phone system.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.