Of all the different investment factors that have been tested and employed over time, value and relative strength have emerged as “best by test.” In other words, when applied consistently over time, these two factors have proven the ability to generate superior performance over buy-and-hold. What is especially great about these two investment factors is that they tend to have a very low correlation to each other. This low correlation allows them to be very good complements.
If all investors cared about was return, then finding uncorrelated strategies wouldn’t be such a big deal. Simply pick value or relative strength and hold on for the long run. However, in the real world, investors have a preference for more stable returns. Value moves in and out of favor, as does relative strength, which presents a dilemma for the investor. Yet, by mixing the two it is possible to reduce the volatility without sacrificing the return too much (and in some cases it can even be augmented.)
Greg Carlson, of Morningstar, recently wrote These Funds Can Ferret Out Value Across Asset Classes in which he screened for some excellent value funds that have the flexibility to change their allocations to equities and fixed income depending on where they find the best value.
Carlson explained his screening criteria:
We used Morningtar’s Premium Fund Screener to sort through the conservative-allocation, moderate-allocation, and world-allocation categories. We set the screener to identify distinct share classes of funds within these categories that are covered by Morningstar’s fund analysts, require no more than $10,000 as an initial investment (we also excluded those that list a minimum initial investment of zero, as these are institutional share classes), and are open to new investors.
We also wanted funds that held up better than the majority of their category peers in 2008 (when the bulk of the market’s decline occurred) and managed to generate at least a 20% gain in 2009. Because last year’s rally was led by speculative, economically sensitive fare, we didn’t want to exclude funds that lagged their category peers in 2009 yet still posted a sizable absolute return. (World-allocation funds gained an average of 25% in 2009, while moderate-allocation funds gained 24% and conservative -allocation funds gained 20%.) Finally, we wanted funds with managers who had been on board for a minimum of five years, beat at least three fourths of their category peers over that span, and had below-average expense ratios.
This screen yielded six funds as of April 19, 2010.
Of the six funds from this screen, I wanted to see how the two biggest funds do when mixed with our Global Macro strategy (available as a separately managed account and as DWTFX.) Our Global Macro strategy is a global tactical asset allocation strategy in which the allocations are driven by a systematic relative strength process.
Efficient frontiers are shown below:
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Given the assets in these two value-based asset allocation funds ($50 Billion in Vanguard Wellington and $12 Billion in Van Kampen Equity & Income), it is no secret that these funds have been successful. However, I suspect that there are many fewer investors who are aware of the potential volatility reduction and increased performance by mixing it with our Global Macro strategy. The correlation of Global Macro and Vanguard Wellington was only 0.34, and only 0.42 for Global Macro and Van Kampen Equity & Income over this time frame.
The potential benefits of mixing value and relative strength are there for the taking.
VWELX and ACEIX returns are taken from Yahoo! Finance. Please note that the Arrow DWA Tactical Fund (DWTFX) was converted to our Global Macro strategy on 8/3/09.
Click here to visit ArrowFunds.com for a prospectus & disclosures. Click here for disclosures from Dorsey Wright Money Management. Past performance is no guarantee of future results.
