Sam Mamudi, MarketWatch, recently profiled deep-value-pioneer Mutual Shares Corp. Click here to read the article. As explained by Peter Langerman, CEO of Mutual Shares Corp, deep value strategies are looking for companies in pre-bancruptcy or that are distressed. As Langerman puts it, “It’s about buying a dollar value for 50 cents.”
Deep value managers, like Mutual Shares Corp, have found an exploitable market inefficiency. This happens to be a very different market inefficiency than we are focused on at Dorsey Wright, but they are very good at what they do. A momentum or relative strength strategy is rarely involved in buying companies in pre-bancruptcy because our methodology leads us to securities that have been the best relative performers over an intermediate time horizon. Both deep value and momentum have a well-documented history of being able to beat the market over time.
However, each strategy has its vulnerabilities. Deep value traps result when distressed securities are bought only to see them become more distressed. Momentum underperforms during every major change in leadership. However, mix the two strategies together and the benefits of diversification become apparent. Creating two strategies so opposite in spirit and opposite in construction, and therefore so negatively correlated with each other, and still having them both produce positive average returns is an area where financial advisors can add meaningful value to their client.
The chart below is the efficient frontier of Dorsy Wright’s Systematic Relative Strength Global Macro strategy and Mutual Shares Corp’s flagship deep-value strategy, TESIX. As you can see, over this time period having 100% of the portfolio in the Global Macro strategy produced the best returns. However, it is possible to lower the annual standard deviation by having a mix of the two. For reference, the S&P 500 generated annualized returns of -1.80% and standard deviation of 17.32% over this same time.
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Yes, in this case mixing the two results in lower overall returns, but that is fine with many people. After all, sticking to a winning discipline for decades is the key to investment success. Many investors get twitchy after very short periods of underperformance. Mixing uncorrelated strategies is a way to address this problem. It is not going to result in outperforming every quarter, but it is likely to result in a smoother ride over time. Such an approach may be enough to keep investors from succumbing to the behavioral biases that will cause them to constantly chase the hottest manager.
Certainly, this type of approach is not without its risks. It is not enough to identify uncorrelated strategies. The goal is to identify uncorrelated strategies that are also both able to generate above average returns over time.
Shortly, we will offer the ability to use our website to create efficient frontiers on your own.
To receive information about our Global Macro strategy, including important performance disclosures, please send an e-mail to [email protected].
Click here for disclosures from Dorsey Wright Money Management.
