Anyone involved in developing and implementing systematic investment strategies should be obsessed with testing. There is no end to the advice you can find about how to invest. The problem for investors is that most of these investment ideas don’t actually stand up to rigorous testing. They may sound good, and they may have worked for a short time period, but when you test them over different market conditions they don’t work as advertised.
We focus on relative strength as the main (or only) factor in our investment process. There has been quite a bit of testing done over the years that shows how well RS/Momentum works over intermediate-term time horizons. There are certainly other factors that stand up to rigorous testing over time, but RS is where we feel we have an exploitable edge over time. Market technicians have used RS/Momentum for many years. The development of computers in the 1960′s even allowed large-scale testing of the idea that strong stocks outperform over intermediate-term time horizons. The academic community got into the act in the early 1990′s, and have continued to research the topic heavily because it was such a blow to long-held academic theories about stock market behavior. With so many different people testing RS using different universes and different formulations for calculating RS, I think it’s safe to say that RS/Momentum strategies can add alpha over time.
What is frustrating about most of this testing is that is very difficult to implement in an actual portfolio. Do you really want to go long 200 stocks and short 200 stocks and rebalance the whole portfolio every month? Not likely. So in the real world, portfolio managers take a factor that has been proven to work, and then begin haphazardly applying it to their style. Is it a sound investment strategy to take a list of high RS stocks and then buy a subset that have “good managements?” Will it work if you cherry pick some stocks with good value characteristics out of the high RS list? What if you don’t rebalance on the same schedule as the RS testing? These are just some of the problems if you don’t implement your strategy exactly as the research was done.
We designed a custom testing process here that determines how robust RS/Momentum is as a factor. Instead of rebalancing each month, quarter, or year we run a continuous process that behaves like an actual portfolio manager would. We also run a Monte Carlo process that buys high RS stocks at random instead of just taking the top ranked stock. This helps us determine what kind of range in outcomes we can expect over time, and what can happen if you get lucky or unlucky in your stockpicking.
In a whitepaper available here we outline our unique testing process using several well-known RS factors. We have a proprietary RS factor we use for our actual portfolio management, but we used well-known factors because people are always amazed that it doesn’t take a “silver bullet” to outperform over time using RS.
[...] can produce great investment results over time. The original blog post on the paper can be found here and the original white paper can be downloaded in pdf format [...]