Advisor Perspectives ran a recent article by Sitka Pacific’s J.J. Abodeely. There was a fantastic quotation he pulled out from Ben Inker at GMO:
“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said. “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”
We’ve written in the past about this exact feature of many winning investment strategies: the arbitrage involved is behavioral, not financial. Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it. In other words, if you look at your portfolio and get a warm, fuzzy feeling, you’re probably doing it wrong.
Simple examples of this phenomenon abound. Here’s one: to lose weight 1) eat less and 2) exercise more. Have I now arbitraged away the entire diet book industry because I just gave you the basic advice for free? Of course not! When I searched Amazon for “The * Diet,” I got 65,338 results (!!), ranging from The Warrior Diet to Crazy Sexy Diet to The Juice Lady’s Turbo Diet. Although I am in awe of publishers’ ingenuity in coming up with great book titles, none of these diets will necessarily work any better than my basic advice. The reason people struggle to lose weight is not because reasonable advice is not readily available; it’s because the advice is hard to implement. Eating less and exercising more is simply less comfortable than our default position of eating more and exercising less!
Relative strength is often an uncomfortable strategy whether it is implemented in equities or global asset classes simply because the portfolios can deviate significantly from the market or from traditional notions of asset allocation. On the plus side, it may give you some comfort to realize that relative strength methods have shown excellent returns for many decades—returns that are not likely to be arbitraged away unless human nature undergoes a substantial change.
Source: www.samdiener.com
[...] “Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it. “ (Systematic Relative Strength) [...]
Hi Mike-
Nice post and thanks for the shout-out. The diet analogy is spot on. I recently attended a DW seminar and I remain undecided about the longevity of RS based strategies. I don’t understand WHY RS would be uncomfortable (beyond benchmark deviation). Aren’t momentum based strategies all about comfort? Or are you simply saying that it works because not many people do it? Feel free to email me directly-
[...] “Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it. “ (Systematic Relative Strength) [...]
RS strategies are difficult because they had larger than index declines and then after than lagged in 2009. For comparison PDP is near perfect correlation to IWP Mid Cap but IWP is the RS winner since the start on a total return basis.
It generally takes RS strategies some time to adapt to abrupt trend changes. The first half of 2008 was bad for the market, but good for RS strategies. The second half of 2008 was bad for the market-and because of the abrupt trend change in energy and basic materials, bad for RS also. Ironically, our separate accounts held no financials, but struggled anyway in late 2008. That’s not typical, as this was not the case for RS in 2001-2002, for example.
The abrupt trend change from down to up in March 2009 also caused RS to lag. Underperforming in a laggard rally is more typical. As I recall, most RS strategies also lagged a bit in 2003. That’s because laggard rallies are typically driven by the stocks that have recently declined the most (in 2009 it was financials; in 2003 it was technology). The stocks that have declined the most have poor RS and are not generally in an RS portfolio.
Value managers typically perform well in laggard rallies, which is one reason why we often recommend combining value and RS strategies. (Value strategies often underperform in periods when RS does well.)
Any correlation with IWP (Russell midcap growth) is a)coincidental and b)a good thing. It’s coincidental in the sense that we happen to own a lot of midcap growth names currently, only because that has been a strong area of the market. Two years down the road we might be highly correlated with large cap value or small cap blend, or any other style box, depending on what is doing well at that time. RS is very adaptive that way, which is a good thing! It’s good in the sense that midcap growth, of all the style boxes, has been one of the strongest. That’s exactly what we would hope to be correlated with recently! If IWP does poorly for the next five years, however, we shouldn’t be very correlated with it. RS will drive the portfolio toward whatever areas are currently performing well.
Thanks for your comment!
So now momentum strategies are “uncomfortable”? I always thought it was value investing that was uncomfortable.
I think it’s actually true in both cases. ANY form of risky investing is uncomfortable. As long as you find a good strategy that you can stick with through thick and thin, you have the potential to do well. Anyone who has a bad strategy, no strategy, or can’t stick to a good strategy is likely to fail. It turns out that most investors land in the failure camp, but it has more to do with conviction than style.
Agree with you on many points. We’ve written many articles suggesting that all successful investment strategies are uncomfortable-both RS and value. Both strategies will have periods of underperformance, and that’s where conviction is important, as you point out.
Most investors do poorly, but it’s not because good investment methodologies are secret. It’s because they do not have the will to stay with a winning strategy during a period when it is under duress.
[...] I am not worried about Fair Value Investing’s edge being arbitraged away by imitators. A blog post by Systematic Relative Strength explains why: We’ve written in the past about this exact feature of many winning investment [...]
Premium uploaded premium…
[...]- Systematic Relative Strength[...]…