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Studying trading strategies in general and stock price behavior in particular is as old as the finance discipline itself. Paul Cootner [1964] collected some of the earliest studies, including Louis Bachelier's Theory of Speculation [1900], which together conclude that market timing strategies do not yield excess returns. Of course, Eugene Farm's [1965] study arguably paved the way for modern investing. He also examined the random character of stock prices and provided evidence suggesting that the market portfolio cannot be outperformed - at least not from price analysis alone. Based on those and many other studies, the plethora of early evidence suggested that investors' best strategy for portfolio management was to hold the market portfolio. Probably the most commonly used practical benchmark for the market portfolio is the S&P 500 Index, but the problem for most individual investors is the numerous frictions associated with forming and managing a replicating portfolio of 500 stocks. The introduction of index mutual funds provided a solution to this problem by giving individuals efficient access to the 500 individual stocks via ownership in one fund.
In addition to index funds, industryspecific mutual funds have also been available for many years and have been the subject of several studies. For example, Dellva et al. [2001] study sector mutual funds and find that managers do not have market timing ability. They attribute their results generally to cash flows in and out of the funds and the managers' focus on performance rather than risk. More closely related to this study, O'Neil [2000] examined the use of industry/sector mutual funds to capture the documented momentum behavior in industries. Over the period 1989-1999, he finds evidence of industry momentum over the intermediate term with the strongest results stemming from holding periods of 12 months. However, while finding evidence of momentum behavior across industries, he also finds that the strategies are more risky than the S&P 500 based on the Sharpe ratio, the Treynor ratio, and Jensen's alpha. Hence, his results suggest that sector mutual funds cannot be employed to outperform the S&P 500 by capturing industry momentum.
More recently, exchange-traded funds (ETFs) were created which offer at least three advantages over mutual funds1 that are particularly valuable to individual investors. Specifically, investors now have the...