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As an active manager, I am always seeking a new and persuasive investment thesis with a good long-term strategy or a strong catalyst. Our discovery process is rigorous with a deep checklist which satisfies sound business and investing principals. These include: differentiation in the marketplace (so not to be riding with the heard); the ability to out-perform major indexes (as an alpha enhancing satellite or core investment); easy to explain (I do not want a herd and do not want to be alone either); and scalable (so serious money can be put to work). One that crossed my desk a couple of years ago has been brought to fruition. It is rules-based and is more passive a strategy than most of our offerings.

It is the Beacon Spin-Off Index (^CLRSO) which is tracked by the Claymore/Beacon Spin-Off ETF (NYSEArca: CSD). The basic premise is that spin-offs; companies which have recently been spun-off from larger corporations, have the opportunity to better focus on their core market segment, better align management compensation with performance, will ultimately outperform.

After first leaning about the concept, our team began its preliminary investigation. We benefited from research written by academics at Penn State University: Cusatis et al., 1993 and Purdue University: McConnell et al., 2004. This got us excited enough to continue our discovery process. We read thorough coverage from consulting firm McKinsey: Anslinger et al., 1999, and then Wall Street firms Goldman Sachs: Stelmach et al., 2006 and Lehman Brothers: Dickson et al., 2006. All these studies support the investment thesis that spin-offs deliver superior investment performance (some of the work can be found here.

It appeared to our team that a diverse group of smart people all came to the same conclusion and that group agreement should be meaningful. After discussion, we kept our enthusiasm but also added a degree of suspicion. Creating an investable product and the work that academics, consultants and researchers perform, regardless of how solid the work, is different than our work. None of our predecessors put money to work. We needed to redo all of the research, albeit with a well defined universe and thesis to test.

The spin-off concept seems intuitive to us. Of course, thinking index versus active strategy was a little foreign for the team. We were born of active money management and not of index publishing. That has changed as we have embraced indexing when appropriate, with an active component. We think in terms of liquidity, volatility, risk, correlation to general indexes and, of course, performance.

Our index is comprised of carve outs and spin-offs. The investment thesis is that when management of a subsidiary is free to pursue its goals unencumbered by the agenda of its parent company and sibling subsidiaries or business units, it will outperform. Additionally, management compensation for the spin-off, in the form of equity, becomes closely aligned to actual performance. When receiving parent company options, obvious dilution occurs by the performance of other business units. We tracked and tested every spin-off and carve out public company over a statistically significant time frame and measured their performance.

We examined each name for suitability and developed specific rules for criteria for inclusion and lifespan. After our rules were set, we rigorously back-tested for performance, market correlation, capacity and liquidity to determine if we would be able to take what was a concept to a live, invest-able index.

Our goal was to find the sweet spot, meaning when to purchase these newly independent companies and rules for ownership duration. One obstacle was determining the curve of the cycle: as they reach a plateau as a mature company and spin-off status is no longer relevant.

We observed, measured and analyzed. Once the optimal settings were found we wrote our rules to describe when and how firms can enter and exit the index.

We then took our universe of stocks and applied our proprietary multifactor models to separate the stronger firms with greater potential from the firms that were spun-off for all the wrong reasons. This produced superior results to simply including every spin-off and is more compatible with our active management nature. We again measured to ensure that alpha was added by each facet, and in concert, of our design process.

When we launched the index, we were fortunate to have found and partnered with Claymore.

It is been a wild market ride since launch.

Looking at our back tests, we observed that in down years we underperform and in up years we well outperform. In October, I ordered tests from the trough of this year (March 9. 2009) through the end of the third quarter (September 30, 2009) to analyze the returns. Clearly CSD has performed as designed and tested. The question now is why the group of stocks that comprise the index outperformed.

Csd

In the pit of my stomach was the fear that this has become a big beta play. That in real life, beyond research or even back-testing that the index when compared to the S&P 500 or a Mid Cap Growth Index was simply higher beta, and perhaps significantly. Beating the S&P 500 this year has been challenging. Beating the Mid Cap Growth Index over this specific time-frame seemed unimaginable.

Bottom line: our index out-performed and has a lower beta than either of the indexes we used for comparison. For invest-ability I used ETFs for comparison; (NYSEArca: SPY) for the S&P 500 and iShares S&P MidCap 400 Growth Index (NYSEArca: IJK) in the graph. One can attribute some of the return to sector weightings. Ultimately, the bulk of the return attribution is due to the investment thesis.

I purchased shares on the day of the IPO so I am still under water. I am holding my shares confident in the work we performed, the research that came before us and attribution analysis we performed in October of this year.

Disclosure: Mr. Corn is the Chief Investment Officer - Equities of Beacon Trust Company. He directs index design and maintenance as well as the firm’s active equity strategies. He is long CSD.

Source: CSD: Spin-Offs Work