Our partners at Arrow Funds have just released their latest newsletter in which they have included a nice analogy on relative strength:
In a sports tournament, a team’s ultimate goal is to win. Likewise, a relative strength portfolio manager uses a tournament approach to narrow a portfolio to a group of the strongest securities. In the first round of the tournament, securities are grouped and compared by asset classes.
Relative strength of individual securities can be used to measure within their asset class to identify the top-performing representatives. In the second round, relative strength is used to compare the strength of each asset class against the asset class universe that was established by the manager.
A portfolio manager uses this process to allocate larger (strong relative strength) and smaller (weak relative strength) positions to these asset classes within the portfolio. The ultimate goal is to put together a team with exposure to the strongest asset classes and securities.
In sports, a tournament ends with a winning team as the champion. That champion will remain until the next season’s tournament. A relative strength tournament in investing also repeats. However, the manager has the ability to alter the frequency of the tournament based on the time frames being used to measure the securities.
