In ForecastCycles there are the following strategies to investigate a potential TOM anomaly in a market:
- TOM FNM: it opens the position at the opening price of the 1st trading day of the new month.
- TOM LPM: it opens the position at the opening price of the last trading day of the ending month.
- TOM L4PM: it opens the position at the opening price of the fourth to last trading day of the ending month.
All the strategies close the position at the closing price of the 3rd trading day of the new month.
Starting from 1987 Ariel’s work, in which he showed that Dow Jones returns in the 1stpart of the month are significantly higher than the ones of the 2ndpart of the month, Lakonishok and Smidt (1987) noted that the performance in the 4 days around the end of the month was 0.473%, while the average of returns over a period of 4 days was 0.0612%. Results can be subsequently filtered to investigate for the “Turn of the Quarter” (or “End of the Quarter”) effect. The "end of quarter effect" refers to the end of each quarter: in March, June, September, and December.
Although the turn of the month is a simple anomaly, it is a big challenge for the academic world to explain the potential reasons for the functionality. The turn-of-the month effect is not concentrated at calendar-year quarter-ends. The reason for functionality also is not a risk-based; the paper has explored whether higher “risk” at the turn-of-the-month can explain this pattern. Using the standard deviation of returns as a measure of risk it was found that risk is not higher during the four turn-of-the-month days than over the other 16 trading days of the month. This implicates that higher risk does not explain the turn-of-the-month effect. Moreover, also a systematic monthly shift in interest rates does not appear to explain the turn-of-the-month pattern in equity returns. Interestingly, the turn-of-the-month effect occurs in 30 different markets, so they concluded that the effect is not due to a factor unique to the U.S. market structure.
On the other hand, Ogden (1990) proposed that the turn-of-the-month effect is due to a “regularity in payment” dates, at least in the U.S., since investors receive a preponderance of compensation from employment, dividends, and interest at month-ends. Consequently, as investors seek to invest these funds, equity prices are pushed up. Unfortunately, the paper provided tests that reject this hypothesis. The overall problem of finding some reason to functionality is also supported by the work of McConnell and Xu: “Equity Returns at the Turn of the Month“ in which they affirm that:
“This persistent peculiarity in returns remains a puzzle in search of an answer.”
However, the majority of the research ascribe this effect to the timing of monthly cash flows received by pension funds, which are reinvested in the stock market. The end of the month is also a natural point for portfolio/trading models rebalancing both for retail and professional investors. The authors cited above, recommend taking caution to implements this strategy in a portfolio, since calendar effects tend to vanish or rotate to different days in a month.
The "end of quarter" periods are considered very important for investors because different data are published regarding various market indicators. It is now widespread the belief that many investment funds and financial companies review the composition of their portfolio at the end of each quarter to change their strategy or to set new goals to adapt their portfolio to the events of the quarter, or to try to get better performance.
A traditional rebalancing that many managers do, is to sell assets that have given good returns during the quarter and buy assets with low performance (losers), with the aim of taking profits on the winning positions and allocating part of these to the loosing stocks, with the hope (supported by mean-reversion studies) that they can turn bullish.
TOM strategy applied on S&P 500
Following, the average return of Forecastcycles TOM strategy on S&P 500. The strategy is the "TOM LPM", it buys at the opening price of the last trading day of the ending month, and sell at the closing price of the third trading day of the new month. It keeps the position open 4 trading days each month.
It can be noticed that the average gross return of the strategy from 1928 to 2021 (0.48%), has been 4.36 times greater than the average return of S&P 500 in 4 trading days (0.11%).
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