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).