New White Paper: Relative Strength and Asset Class Rotation

March 11, 2010

In January we published a white paper that outlined our testing process, and illustrated why we believe applying relative strength in a systematic fashion 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 here.

We received a lot of positive feedback on the original paper. In the first white paper, we tested several relative strength factors on a universe of mid- and large-cap U.S. equities. The new research expands on the original work by testing a variety of relative strength factors on a universe of asset classes. The investment universe for this white paper is domestic sectors, domestic styles, alpha generating, global equity, international equity, inverse equity, real estate, commodities, currencies, government bonds, and specialty fixed income. The complete white paper on relative strength and asset class rotation can be downloaded here.

If you are a frequent reader of our blog you are well aware of our feelings about the Tactical versus Strategic Asset Allocation debate. We believe Tactical Asset Allocation is a much better way to invest than Strategic Asset Allocation. In the white paper, we show how a Tactical strategy can be implemented in a real-world setting. We find that concentrating on strong asset classes can lead to outperformance over time. We also use our Monte Carlo process to test the robustness of those findings. Finally-and very importantly-we show how the volatility of an asset class rotation portfolio changes over time.

When volatile assets, such as stocks, are declining, an RS strategy might rotate into a much less volatile asset class, like bonds or currencies, that is holding up better. This is very different from the approach taken by a Strategic Asset Allocation portfolio. An important byproduct of using relative strength is that the portfolio adapts to changing market conditions. Perhaps the most powerful image from the white paper is Figure 2, which shows the trailing 12-month beta of the model versus the S&P 500, as well as for a 60/40 benchmark versus the S&P 500:

As shown, a tactical approach to asset allocation allows the risk to increase and decrease depending on the market environment. Our experience has been that this is exactly what clients want and need. They need a dynamic process that seeks to protect them during the bad times, but one that is flexible enough to capitalize during the good times.

We’re excited about being able to share this research about using relative strength to manage a tactical allocation portfolio. We use a similar process (although we don’t pick investments at random!) to run our Systematic Relative Strength investment strategies. Our asset class rotation strategy is available via our Global Macro separate account (click here for the fact sheet), or through a mutual fund (DWTFX) we manage through Arrow Funds (click here for the fact sheet).

2 Comments | Relative Strength Research, Tactical Asset Alloc | Permalink
Posted by Andy Hyer

Ibbotson Kills Strategic Asset Allocation

March 11, 2010

Today we celebrate the death of another myth-that asset allocation is responsible for 90% of your return-surprisingly done in by none other than Roger Ibbotson of Ibbotson Associaties, purveyors of the ubiquitous asset class return charts. This myth is particularly pernicious because it is used by strategic asset allocators of all stripes to imply that active management or stock picking doesn’t really matter-if you just allocate properly you will be fine.

There are two problems with the myth that asset allocation is responsible for 90% of your returns: 1) the original Brinson et al. (BHB) study actually said that asset allocation explained 90% of the variation in returns between two sets of institutional portfolios, and 2) even that was wrong. In his recent article in the Financial Analysts Journal, “The Importance of Asset Allocation.” Roger Ibbotson writes:

Surprisingly, many investors mistakenly believe that the BHB (1986) result (that asset allocation policy explains more than 90 percent of performance) applies to the return (the 100 percent answer). BHB, however, wrote only about the returns, so they likely never encouraged this misrepresentation.

Whether BHB ever encouraged it or not, the misreading of the results was seized upon by hungry marketing departments everywhere to serve their own purposes.

Calculating the actual impact of active management versus the impact of asset allocation is actually pretty tricky. There have been several different studies that address it and their numbers vary, depending on the time horizon and the type of portfolio. Ibbotson’s own research into this area concludes:

Ibbotson and Kaplan (2000) presented a cross-sectional regression on annualized cumulative returns across a large universe of balanced funds over a 10-year period and found that about 40 percent of the variation of returns across funds was explained by policy.

Clearly, 40% is a whole lot different than 90%. It turns out that active management and stock selection is way, way more important than the strategic asset allocation crowd would like to admit.

Tactical asset allocation and active management may have a major role if investor returns are significantly dependent not just on how you are allocated, but on exactly what you own and when. Ibbotson’s article points out that:

The time has come for folklore to be replaced with reality. Asset allocation is very important, but nowhere near 90 percent of the variation in returns is caused by the specific asset allocation mix. Instead, most time-series variation comes from general market movement, and Xiong, Ibbotson, Idzorek, and Chen (forthcoming 2010) showed that active management has about the same impact on performance as a fund’s specific asset allocation policy.

The emphasis is mine, but the “replacing folklore with reality” phrasing is pretty strong for an academic journal. Modern portfolio theory and its near cousin, strategic asset allocation, however, seem to be dying a lingering death. It is still the dominant method of structuring portfolios, but clearly it is just as important to consider tactical asset allocation and to make sure that active management processes are robust. The next time you read the 90% number somewhere, I hope you will give it the consideration it deserves—none.

7 Comments | From the MM, Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

Fund Flows

March 11, 2010

The Investment Company Institute is the national association of U.S. investment companies, including mutual funds, closed-end funds, exchange-traded funds (ETFs), and unit investment trusts (UITs). Members of ICI manage total assets of $11.82 trillion and serve nearly 90 million shareholders. Flow estimates are derived from data collected covering more than 95 percent of industry assets and are adjusted to represent industry totals.

Net fund flows are shown in the table below:

Continuing the trend in fund flows, there were big inflows into taxable bond funds in the week ending March 3. However, foreign equity also saw good inflows for a change. Domestic equities continue to lose the popularity contest among retail mutual fund investors.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer