Systematic Relative Strength

If you strip things down to their bare essentials, the only reason investors buy equities is to capture the elusive “equity risk premium.” The equity risk premium is simply the excess return to be had in equities over a riskless asset like Treasury bills. At least theoretically, equities are supposed to come with a higher return because the risk is higher.

If you are only interested in capturing the equity risk premium, you should buy an index fund. Whatever the equity risk premium turns out to be, an index fund will capture it at minimal cost. An index fund will never underperform, thus assuring that you will fully capture whatever risk premium is available. Of course, it will never outperform either.

Many investors want to do better than that. They opt for active managers in an attempt to capture alpha in addition to the equity risk premium. Whatever methodology is chosen—whether it is GARP, value, or in our case, relative strength—will require patience. It’s well known, for example, that value and growth managers can be out of synch with the market for large parts of the business cycle, often for years at a time. This is not necessarily a failing of the strategy, just the price you have to pay to get the alpha you seek. Christopher Davis, the manager of the New York Venture Fund, recently made this point at a Morningstar conference. He said, “if clients can’t deal with three years of underperformance from an active manager, then they should be in index funds.”

Temporary underperformance, I think, is one of the hardest things for clients to deal with. Studies, and our own experience, show that relative strength can get out of synch too, although the failure periods are often shorter than with other methods. Pleas to clients to sit tight often fall on deaf ears, even when they can look at compelling longer-term data that shows good performance.

It might help a client to reframe the question, since it often is about more than just capturing the equity premium. If you are temporarily fussing about your active manager, ask yourself whether you would really rather buy an index fund to track the equity market. After all, you would never again have to be irritated with underperformance. Many clients say, “Well, but I could never outperform either!” That’s right. The cost of long-term outperformance in every successful strategy is an occasional bout of underperformance.