CSat Market Neutral Fund: CSat Investment Advisory

Winner: Best equity market neutral hedge fund

‘The customer is always right' has been the mantra of many successful businesses. The same principle can be applied to investing, says Thomas Kratky, a managing director at CSat, a hedge fund that relies on customer satisfaction data to pick stocks.

"It's self-evident that companies with satisfied customers are likely to outperform those with unsatisfied customers," says Kratky. "What's surprising is that so few investors appear to consider customer satisfaction as a driver of equity returns."

[Pictured: Thomas Kratky, managing director, CSat Investment Advisory]

CSat bases its investment decisions purely on data from and analysis of the American Customer Satisfaction Index (ACSI), a monthly consumer sentiment indicator created by Claes Fornell, CSat's founder and chairman.

Fornell is a professor of business at the University of Michigan and a leading authority on customer satisfaction and its relationship to profitability, productivity and stock performance.

The ACSI, which Fornell founded in 1994, surveys around 70,000 households each year about their consumption habits and experiences. The responses are fed into an econometric model developed by Fornell that quantifies their level of satisfaction with 235 companies in 47 industries.

The CSat Market Neutral Fund invests in the stocks of companies with high levels of customer satisfaction as measured by the ACSI and sells short companies that receive the most negative response from consumers.

The strategy has produced impressive results. The fund has generated annualised returns of 8.8% since inception in July 2006 with standard deviation of 6.6% and no losing years. In the same period, the S&P 500 has returned only 2.7% with volatility of 17.9%.

CSat has recorded a success ratio of 62% on its long trades. Its winners outperform the market by 24% on average, while its losing trades underperform by only 15%.

The CSat Market Neutral Fund is equally weighted between a long portfolio of 20 to 40 stocks and a short portfolio, which consists of five to 20 stocks and market hedges in the form of S&P 500 futures and sector ETFs. The fund's gross exposure ranges from 180% to 240%, with a target net exposure of zero.

The portfolio is invested mostly in large caps with a bias for "market leaders or very large companies within their sectors", says Kratky.

In selecting stocks for the portfolio, CSat looks at a couple of additional factors beyond the pure ASCI score.

First, it measures the strength of the relationship between customer satisfaction and equity returns in various industries, a factor it calls "elasticity".

Kratky says customer satisfaction is a particularly strong indicator of stock performance in sectors where there is a high level of competition and choice for consumers. Elasticity tends to be weakest in monopolistic sectors, such as airlines and tobacco.

CSat also analyses customer expectations of companies in different industries and adjusts the weight it places on ACSI scores accordingly. "A customer's expectations when they walk into a fast food restaurant are not the same as when they visit a luxury car dealer. We take that into consideration," says Kratky.

The raw data collected by the ACSI is plugged into CSat's investment model, which calculates an elasticity and expectation-adjusted customer satisfaction score for each company in the index. The entire process is 100% quantitative.

CSat's returns are uncorrelated to the performance of the S&P 500 or traditional market factors such as growth, value and momentum.

The fund gained 9.5% in 2008 and was up 7.81% in 2009. It returned 5.65% in 2011 and was up 8.75% for 2012 through the end of May.

"The strategy is simple but intuitive," says Kratky. "Economic theory is based on the concept of utility, which can be defined as the amount of satisfaction or benefit that an individual gains from consuming goods or services in an economy. It is a basic tenet of economics that companies with high utility will attract capital."

He illustrates how the strategy works with an example from the auto sector.

CSat exited a long position in Toyota in August 2009 when the latest ACSI data showed a sharp drop in the company's customer satisfaction scores. "The score was not low enough for us to short the company but it was pretty close," says Kratky. In November, Toyota announced the first of a series of recalls related to braking and acceleration problems with its vehicles, causing the company's stock price to drop sharply.

Around the same time the fund entered a long position in Ford on the back of ACSI data showing customer satisfaction with the company was rising dramatically. Ford's stock price nearly doubled from $7 on October 30, 2009 to $13.02 on April 30, 2010.

Fund facts
Fund name: CSat Market Neutral Fund
Management company: CSat
Contact information: Thomas Kratky ([phone]; [e-mail])
Launch date: July 2006
Assets under management: $150 million (at June 2012)
Annualised return: 8.8% (at June 2012)
Annualised volatility: 6.6% (at June 2012)
Sharpe ratio: 1.3
Strategy: quantitative market neutral
Administrator: UBS
Auditor: Plante & Moran
Prime broker: Goldman Sachs
Legal counsel: Akin Gump Strauss Hauer & Feld
Management fee: 2%
Performance fee: 20%
Redemption/liquidity terms: monthly with 30 days' notice