Is the Rent Due?

March 18, 2010

A recent article in The Economist discusses the outlook for inflation and interest rates in the United States. It points out that the core rate of inflation in February (1.3%) was at its lowest point in six years. This has allowed the Fed to state in their March 16 meeting that they would probably keep rates low (0-0.25%) for an extended period of time. Inflation and interest rates have a major influence on the capital markets and the U.S. dollar, so it behooves one to pay attention to their movements and what may cause them.

The single largest component of the core rate of inflation is housing costs. This big boy weighs in at over 40% of the core CPI. The proxy used for housing cost is the what someone would have to pay in order to rent the house he owns. Rents have declined a great deal during the economic downturn; so much so, that if they were excluded, the core CPI would have gone up rather than down over the period. Of course there are many other factors that influence core inflation, but the future of the dollar and the capital markets may well be largely in the hands of your landlord.

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Posted by Harold Parker

Stretch Your Investing Style

March 18, 2010

In an article in Smart Money with this title, author Reshma Kapadia advocates “go anywhere” funds as a useful component for investor portfolios. The global asset allocation fund has become much more popular over the past couple of years, possibly for reasons of diversification, flexibility, and performance.

Financial advisers say the flexibility of these go-anywhere funds is even more important at a time when markets are contending with so much uncertainty. “These managers are in the trenches,” says John Eckel, a fee-only planner at Pinnacle Investment Management. “We don’t want to tie their hands.” In the wake of the credit crisis, advisers are reassessing how they diversify assets, increasingly opting to delegate the task to professional money managers, says Loren Fox, senior research analyst at Strategic Insight.

For many of the funds, flexibility seems to be linked to the ability to extract returns from multiple asset classes, particularly when domestic equities have offered such low returns over the last decade.

… global flexible funds, a proxy for managers with the most latitude, have handily outperformed Standard & Poor’s 500 index. These funds returned an average of 4.5 percent a year over the past five years, while the S&P 500 was essentially flat, according to research firm Lipper. The go-anywhere funds lost money during the crash but still held up much better than the broader market, a fact not lost on some planners.

Both of the Arrow Funds managed by Dorsey, Wright (DWTFX and DWAFX) fall into the global allocation category. Another fund mentioned in the article is Blackrock Global Allocation (MDLOX), which has grown to be an enormous $36 billion fund.

Blackrock goes at global allocation from a valuation standpoint, while the Dorsey, Wright managed funds take a relative strength approach. The two methods complement one another unbelievably well. Andy wrote an earlier post, “Global is the New Core,” showing an extraordinary efficient frontier with returns from Blackrock Global Allocation and our Global Macro strategy (separate account and DWTFX). To see this piece of financial pornography, click here. WARNING: ADULT CONTENT-seasoned financial professionals only!

If you are doing portfolio construction or asset allocation, this chart is hotter than Brooklyn Decker in the Sports Illustrated swimsuit issue. Blackrock Global Allocation is an enormous fund and probably some financial advisor out there could spend an entire quarter adding the Arrow DWA Tactical Fund (DWTFX) to all of his or her accounts that owned Blackrock. [ Not that we would advocate such a strategy. :) ] The broader point is that investors are now open to considering a more flexible, more global approach than at any point in the past.

Leave a Comment » | Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Mike Moody

China: 30-Year Path to Becoming an Economic Powerhouse

March 18, 2010

At the end of the Cultural Revolution in 1976, China’s planned economy was in ruins and its people barely surviving. Oh, how things have changed for the Chinese economy since reformer Deng Xiaoping initiated free market reforms beginning in 1978. China has developed from an economically desolate and ideologically driven country into an industrial powerhouse. From virtually an industrial backwater in 1978, China is now the world’s biggest producer of concrete, steel, ships, and textiles, as well as the world’s biggest auto market.

During the 1990s, Premier Zhu Rongji started a policy of privatizing money-losing state enterprises. In 1997, the CPC issued a verdict declaring that state-owned companies were now “people-owned companies” who would be subject to mergers and bankruptcy. Thousands of state companies were privatized or partly floated on the stock exchange. In 1978, more than 90% of GDP was produced in state enterprises, which, up to 1992, dominated China’s economy. That figure, not accounting for state assets that were contracted, had fallen to 30% by 2009.

With that context, consider today’s New York Times article “China Drawing High-Tech Research From U.S.” I have copied a few particularly interesting sections from that article below:

For years, many of China’s best and brightest left for the United States, where high-tech industry was more cutting-edge. But Mark R. Pinto is moving in the opposite direction.

Mr. Pinto is the first chief technology officer of a major American tech company to move to China. The company, Applied Materials, is one of Silicon Valley’s most prominent firms. It supplied equipment used to perfect the first computer chips. Today, it is the world’s biggest supplier of the equipment used to make semiconductors, solar panels and flat-panel displays.

In addition to moving Mr. Pinto and his family to Beijing in January, Applied Materials, whose headquarters are in Santa Clara, Calif., has just built its newest and largest research labs here. Last week, it even held its annual shareholders’ meeting in Xi’an.

It is hardly alone. Companies — and their engineers — are being drawn here more and more as China develops a high-tech economy that increasingly competes directly with the United States.

“If you really want to have an impact on this field, this is just such a tremendous laboratory,” he said.

Xi’an — a city about 600 miles southwest of Beijing known for the discovery nearby of 2,200-year-old terra cotta warriors — has 47 universities and other institutions of higher learning, churning out engineers with master’s degrees who can be hired for $730 a month. [my emphasis added]

Locally, the Xi’an city government sold a 75-year land lease to Applied Materials at a deep discount and is reimbursing the company for roughly a quarter of the lab complex’s operating costs for five years, said Gang Zou, the site’s general manager.

When Xie Lina, a 26-year-old Applied Materials engineer here, was asked recently whether China would play a big role in clean energy in the future, she was surprised by the question.

“Most of the graduate students in China are chasing this area,” she said. “Of course, China will lead everything.”

While I highly doubt that China will “lead in everything,” the economic development of China over the past 30 years has been breathtaking.

I don’t know how a U.S. investor today would even consider approaching their investment planning without broadening their personal investment universe to include China and the rest of the world. Perhaps, the biggest deterrent to expanding one’s investment universe beyond U.S. borders is fear of the unknown. Education about the rest of the world will certainly help overcome that hurdle. Furthermore, investors who use global relative strength strategies can take comfort in knowing that the allocations are determined by a very familiar relative strength factor which seeks out the strongest trends, regardless of where in the world they are found.

Leave a Comment » | Markets, Tactical Asset Alloc, Thought Process | Permalink
Posted by Andy Hyer

Fund Flows

March 18, 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:

For the first time in a long time, US equity flows are off the bottom of the ranks. While taxable bonds still attracted the most new fund flows in the week ending 3/10/2010, domestic equities rose to the middle of the pack.

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Posted by Andy Hyer

RS in Australia

March 18, 2010

Blog reader, Matthew Brooks, writes:

By the way, relative strength is a great strategy for selecting stocks in Australia also. I just published a book that looked at the stock market strategies that work in Australia.

http://www.thesuperinvestor.com.au/order_book.php

It’s a bit like What Works On Wall Street … but for stocks listed on the ASX. Relative Strength was the single best criteria in Australia. Thought you might be interested as the Bibliographies on some of your reports read like a list of my favourite books.

Looks like an interesting book. It is not surprising to see that relative strength works all over the world, given the fact that RS capitalizes on trends, and trends certainly aren’t confined to the U.S.

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Posted by Andy Hyer

Trend Following Beats Market Timing

March 17, 2010

Mark Hulbert has been tracking advisory newsletters for more than 20 years. Lots of these newsletters are active market timers, so in a recent column, he asked an obvious question:

The first question: How many stock market timers, of the several hundred monitored by the Hulbert Financial Digest, called the bottom of the bear market a year ago?

And a follow-up: Of those that did, how many also called the top of the bull market in March 2000 — or, for that matter, the major market turning points in October 2002 and October 2007?

If you are relying on some type of market timing to get you out of the way of bear markets and to get you into bull markets, this is exactly what you want to know. Although there are pundits who claim to have called the bottom to the day, Mr. Hulbert allowed a far more generous window for labeling a market timing call as correct.

… my analysis actually relied on a far more relaxed definition: Instead of moving 100% from cash to stocks in the case of a bottom, or 100% the other way in the case of a top, I allowed exposure changes of just ten percentage points to qualify.

Furthermore, rather than requiring the change in exposure to occur on the exact day of the market’s top or bottom, I looked at a month-long trading window that began before the market’s juncture and extending a couple of weeks thereafter.

That’s a pretty liberal definition: the market timer gets a four-week window and only has to change allocations by 10% to be considered to have “called” the turn. And here’s the bottom line:

Even with these relaxed criteria, however, none of the market timers that the Hulbert Financial Digest has tracked over the last decade were able to call the market tops and bottoms since March 2000.

Yep, zero. [The bold and underline is from me.] It’s not that advisors aren’t trying; it’s just that no one can do it successfully, even with a one-month window and a very modest change in allocations. Obviously, there is lots of hindsight bias going on where advisors claim to have detected market turning points, but when Mr. Hulbert goes back to look at the actual newsletters, not one got it right! You can safely assume anyone who claims to be able to time the market is lying. At the very least, the burden on proof is on them.

We don’t bother trying to figure out what the market will do going forward. We simply follow trends as they present themselves. We use relative strength in a systematic way to identify the trends we want to follow: the strongest ones. We stay with the trend as long as it continues, whether that is for a short time or an extended period. When a trend weakens, as evidenced by its relative strength ranking, we knock that asset out of the portfolio and replace it with a stronger asset. The two white papers we have produced (Relative Strength and Asset Class Rotation and Bringing Real World Testing to Relative Strength) show quite clearly that it is possible to have very favorable investment results over time without any recourse to market timing at all. Discipline and patience are needed, of course, but you don’t have to have a crystal ball.

10 Comments | Markets, Thought Process | Permalink
Posted by Mike Moody

Are Stock Funds Poised for Inflows?

March 17, 2010

At MarketWatch, Sam Mamudi has an interesting article about investor purchases of mutual funds. The article points out that when investors have been traumatized by a bad market-like now-they tend to wait around for a while before being confident about getting into the market once more.

The overall flow numbers also fit a pattern. This is the fourth bull market since 1987, according to Standard & Poor’s Equity Research. Each time, net inflows into stock funds have been slow to get going before jumping in the second year.

In the first 12 months of 1987′s bull market, for example, stock funds saw $16 billion in net outflows, but that was followed by a cascade of more than $4 billion in new money over the following year. A similar surge in 1990′s bull market: Net inflows were roughly $26 billion in the first year and more than $70 billion over the next year. And the first year of the bull market that began in late 2002 saw about $90 billion in net stock fund inflows, jumping to $190 billion in the second year.

Although 2009 was the best stock market in a decade, there was very little participation from mutual fund investors. That may be about to change during the second year after the trough. If mutual fund flows indeed pick up in 2010, we may see a better market than most currently expect.

Leave a Comment » | Investor Behavior, Markets, Sentiment | Permalink
Posted by Mike Moody

Don’t Fight the Tape

March 17, 2010

Whether you are inclined to be bearish or bullish, James Altucher has a nice list of talking points in his recent WSJ article. The talking points touch on the following issues: home foreclosures, GDP growth, unemployment, the Obama stimulus, P/E ratios, inflation, municipal bonds, and commercial real estate. For the bears, your talking points are in bold. For the bulls, your talking points are in bullet points.

However, for us trend followers, the market (U.S. equities in this case) has just broken out to new cyclical highs:

Source: StockCharts.com

There is a reason for the market axiom “Don’t Fight the Tape” - fighting the trend is hazardous to your wealth.

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Posted by Andy Hyer

RS Diffusion Index

March 17, 2010

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.) As of 3/16/10.

The 10-day moving average of this indicator is 91% and the one-day reading is 94%. This oscillator has shown the tendency to remain overbought for extended periods of time, while oversold measures tend to be much more abrupt.

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Posted by Andy Hyer

Relative Strength Spread

March 16, 2010

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 3/15/2010:

The RS Spread has spent the last couple of months going sideways, after the sharp decline in the spring of 2009. Given the historical tendency for relative strength to move in and out of favor (with the periods when it is in favor more than compensating for the periods when out of favor), it is likely that this transition will lead us into a much more favorable environment for relative strength investing.

2 Comments | Markets | Permalink
Posted by Andy Hyer

Relative Strength Is Everywhere

March 15, 2010

CXO Advisory recently published another study on momentum (otherwise known as relative strength) and style rotation. Not surprisingly, their conclusion was:

In summary, a simple style momentum strategy implemented with ETFs may perform well compared to the overall stock market and individual style ETFs.

Since we have been using style funds in some of our relative strength strategies for years, we could have told you the same thing, but it is always nice to have some validation by a completely independent party.

Relative strength is an incredibly adaptable method. We’ve demonstrated in our own white papers that it works nicely with stocks and asset classes. It works for industry rotation and style rotation. There is lots of third-party validation as well, whether from CXO Advisory here, other practitioners, or academics.

One of the things I particularly like about relative strength is that it can deal with a disparate basket of assets, which is considerably more difficult with other proven return factors like deep value. Value is not too tricky when comparing two similar assets, like two stocks. If you want to get more sophisticated, you can even build a complicated model to determine if stocks are cheaper than bonds. But how easy is it to determine whether crude oil, Apple Computer, or emerging market debt is cheapest? The assets and the metrics typically used to value them are not universal. With relative strength-no problem. It’s not difficult to determine which is the strongest asset and it can be done on an apples-to-apples basis.

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Posted by Mike Moody

Mohammed El-Erian: Don’t Look Back

March 15, 2010

Mohammed El-Erian of Pimco had a recent commentary, posted here at Advisor Perspectives, on the sovereign debt explosion. He talked about different ways in which it could be resolved-some good, some not so good.

One of the points he makes is particularly relevant to investors watching the process unfold and trying to make investment decisions prospectively:

We should expect (rather than be surprised by) damaging recognition lags in both the public and private sectors. Playbooks are not readily available when it comes to new systemic themes. This leads many to revert to backward-looking analytical models, the thrust of which is essentially to assume away the relevance of the new systemic phenomena.

There is always a tendency to rely on what has worked in the past. Often that makes sense; there is usually some commonality of conditions. Yet the exclusive reliance on past paradigms can get you into trouble, especially if you don’t notice that linkages and relationships are subtly different than in previous episodes.

Relative strength, because of its insistence on what is, is often a very fruitful way of looking at a situation with fresh eyes. We know that debt-driven financial crises have occurred before and will again. What we don’t know is how, in subtle ways, they will play out slightly differently than in the past. Relative strength can keep us focused on the here and now-this is what the market thinks right now-which can keep us from adopting backward-looking analytical models that may fail going forward.

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Posted by Mike Moody

Yes Man

March 15, 2010

Although Jim Carrey was in a comedy with this title, the reference here is decidedly darker. A new study reported in Fortune and co-authored by Sendhil Mullainathan, a Harvard professor and MacArthur Foundation genius grant recipient, suggests that most financial advisors are enablers and tend to go along with their clients’ wishes, even when the clients are way off base.

Most planners, his report finds, reinforce our bad investment behaviors instead of fixing them.

The implication of the Mullainathan study is that advisors are incompetent or unethical, but I don’t think that’s the case at all. The problem is that advisors have learned through experience that investors won’t accept good advice-so they tell investors what they want to hear in order to keep the client. The problem is not an easy one to solve and here’s why:

Finally, the yes-man problem can’t just be pinned on advisers. A 2007 survey from the Employee Benefit Research Institute found that two-thirds of the people interested in meeting with a financial planner were likely to implement advice only if it conformed to their own ideas.

Investors are afflicted with an overconfidence bias-they think they know what they are doing-so they tend only to listen to advice they already agree with. The advisor is often put into the position of sussing out what the client’s biases are and then trying to approximate good advice, but only being able to go as far as the client will accept. No doubt this leads to a lot of advisor stress and investor underperformance.

We’ve always tried to be upfront with our opinions, even if the (often ill-informed) client doesn’t agree. Sometimes we get a frustrated client, but more often than not they rise to the occasion and listen. Smart clients are willing to question their assumptions, examine the relevant data, and consider a different point of view-and those are the clients we want anyway.

Leave a Comment » | Investor Behavior, Thought Process | Permalink
Posted by Mike Moody

Will We Get a Hollywood Ending?

March 15, 2010

Everyone has seen some version-action movie or cartoon-of the canoe headed toward the waterfall. Sometimes the protagonist is aware of impending doom; sometimes it catches them by surprise. Lots of times, at least in the movies, there is a Hollywood ending whereby the hero is miraculously saved from going over the falls, or even more miraculously, goes over the falls and survives.

The global debt situation is like that now for the four large countries remaining with AAA credit ratings. Those four countries are the U.S., U.K., France, and Germany, and according to the Wall Street Journal

The credit-rating company repeated that there was no immediate risk of a downgrade of the big triple-A-rated countries, although the slight risk they could fail to get their finances under control, and thus be downgraded, has increased. Moody’s concluded that “on balance, we believe that the ratings of all large triple-A governments remain well positioned—although their ‘distance-to-downgrade’ has in all cases substantially diminished.”

As far as I can tell, “distance-to-downgrade’ is a polite way of informing these countries that if they listen carefully, they will be able to hear a waterfall in the background.

One of the interesting things about currencies is that all of the movement is relative to other currencies. You may be in bad fiscal shape, but you might still have a strong currency if your neighbor’s condition is even worse.

The dollar was having a tough time of it against the Euro until it came out that several members of the EU had very large and in some cases, undisclosed, debt problems. Now the Euro is floundering. The recent strength in the dollar has allowed dollar-denominated assets, like U.S. stocks, to improve in performance versus international stocks. In a purely domestic portfolio, you would probably never notice this, but its effect is very apparent in a global macro-type account.

It’s not clear how things will shake out. Will our policy makers rescue us before we go over the falls, or at least protect our currency better than the other governments? Or will we all go over the falls together? One thing that does seem certain is that the global enonomy is more linked than ever before, and that investors will have to account for this in their investment portfolios.

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Posted by Mike Moody

Weekly RS Recap

March 15, 2010

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile and quartile and then compared to the universe return. Those at the top of the ranks are those stocks which have the best intermediate-term relative strength. Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong.

Last week’s performance (3/8/10 – 3/12/10) is as follows:

The top quartile performed roughly in line with the universe last week, while the best performance came from the laggards.

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Posted by Andy Hyer

Dorsey Wright Sentiment Survey

March 12, 2010

We’d like to introduce the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll. As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions! Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients. It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog-but we need your help to get a large statistical sample!

Contribute to the greater good! You WILL NOT be directed to another page by clicking the survey. It’s painless, we promise.

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Posted by JP Lee

The Endowment Portfolio Rides Again

March 12, 2010

Yale University has had one of the best-performing endowment portfolios over the past decade and more. Yale’s Chief Investment Officer, David Swensen, farms out all of the money to outside managers, watches costs, and diversifies broadly. He believes that an equity-oriented portfolio is necessary for growth, but one of his hallmarks has been significant exposure to alternative assets that might provide equity-like growth. Yale’s endowment typically maintains a 15-25% exposure to private equity and includes investments in hedge funds as well, so it’s not something that can be easily replicated by Mr. Jones.

In an article, “A New Yale Tale,” in the most recent issue of Financial Planning, Craig Israelson, Ph.D, a professor at BYU, asks the following question:

The Yale Endowment Fund has excelled through all kinds of markets. Is it possible to build a similar portfolio that is accessible to everyone?

He goes on to build a multi-asset replication portfolio that owns 12 equally weighted ETFs.

Beneath the seven core asset classes in the multi-asset portfolio are 12 ETFs in the following sub-asset classes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, global real estate, resources, commodities, U.S. aggregate bonds, U.S. Treasury inflation-protected securities, non-U.S. bonds and U.S. money markets. The 12 ETFs have equal weights and are rebalanced annually.

This is an elegant solution and Dr. Israelson provides a nice table of returns that shows how the multi-asset portfolio, while not quite on par with Yale’s endowment, performs much better than the Vanguard 500 Index and the Vanguard Balanced (60/40) Index over the last decade. In addition, the volatility is much lower than Yale’s portfolio. How does it accomplish such a feat?

Both the Yale Endowment and multi-asset portfolio view alternative assets as critically important components of a well-diversified portfolio. Why? Because including nontraditional assets enhances performance and reduces risk.

There is some truth to this in terms of including alternative assets in the mix, but it is also the case that almost every asset class performed better than domestic equities over the last decade. Owning mid-caps, small-caps, commodities, and resources ensures that you did much better than the Vanguard 500 over the last ten years-but what about the next ten years? What happens if domestic equities are one of the top asset classes going forward? A passive portfolio with a fixed (and limited) exposure to stocks might lag substantially.

One possible solution to this problem is the Arrow DWA Balanced Fund (DWAFX). It has many of the attributes of the Yale Fund: it is equity-oriented, with holdings in domestic and international equities, but also includes fixed income and alternative assets like precious metals, real estate, and inflation-protected securities. Unlike the passive 12-ETF portfolio, however, the allocations are made tactically and the size of the allocation can vary (within a range) depending on the current relative strength of an asset class. This gives the portfolio wide latitude to adjust its exposure as market conditions change. In other words, good performance is not so dependent on the next ten years looking like the last ten years!

click to enlarge

Click here for a historical performance disclosure.

Above we have replicated Dr. Israelson’s table of returns, but we’ve added a new column for DWAFX. Using the tactical strategy over the last decade has resulted in both higher returns and lower volatility than the 12-ETF solution. The key gain from a tactical approach is flexibility-the asset weights are not fixed and thus can respond to new environments. Higher returns and lower volatility are a pretty nice combination for investors looking for both stability and flexibility in their long-term portfolio. DWAFX’s trailing three-year performance is in the top 15% of all moderate allocation funds according to Morningstar (as of 3/11/2010). If you have a client looking for a foundational product for a portfolio, DWAFX might fit the bill. You can find at more at Arrow Funds.

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

Sector and Capitalization Performance

March 12, 2010

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s). Relative strength strategies buy securities that have strong intermediate-term relative strength and hold them as long as they remain strong. Performance updated through 3/11/2010.

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

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).

1 Comment | Relative Strength Research, Tactical Asset Alloc | Permalink
Posted by John Lewis

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.

6 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

Avoiding Turmoil in the Bond Market

March 10, 2010

The Federal Reserve has kept the discount rate incredibly low for a long time. At some point, they will need to increase it. But how?

An article in the Wall Street Journal points out how careful the Fed has to be, even with its language, in order to tighten without creating a ruckus.

At some point, the Fed must undertake some delicate wordsmithing in the statement it releases after policy meetings.

I admit I am very curious to see how this will be accomplished. Changes in Fed policy have been communicated successfully in the past-and they have also been botched. Markets tend to trade on expectations, well ahead of reality. With so many people hanging on every word from the Fed, it will be interesting to see if the market will react calmly or violently when the Fed signals a move away from the low-rate regime.

Leave a Comment » | Markets | Permalink
Posted by Mike Moody

High RS Diffusion Index

March 10, 2010

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.) As of 3/9/10.

The 10-day moving average of this indicator is 80% and the one-day reading is 91%. This oscillator has shown the tendency to remain overbought for extended periods of time, while oversold measures tend to be much more abrupt.

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

One Source of Cash for a Bull Run

March 10, 2010

The Financial Times points out that lots of cash piled into government debt last year in a quest for safety.

In 2009, investors bought almost $250bn of dollar-denominated bonds sold by US and European banks, all with triple A guarantees from US and European governments.

Now, as the government-guaranteed bonds sold during the crisis start to mature and get repaid, investors are wondering where to reinvest the cash they receive.

As it matures, no doubt much of it will be reinvested in the bond market. But some of it, given the strong performance of global equity markets, might leak into stocks. Given that the size of the debt markets are many times the size of world stock markets, even a little flow could create a nice situation in stocks.

Leave a Comment » | Markets | Permalink
Posted by Mike Moody

Economics in One Picture

March 9, 2010

From Greg Mankiw’s blog, economics in one picture. This nicely captures the principle of supply and demand!

Leave a Comment » | Just for Fun, Markets | Permalink
Posted by Mike Moody

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