Casting Out = Upgrading

January 3, 2012

From the New York Times, a look at how DAL Investments has managed to beat the market:

DAL, which manages $1.3 billion, has been using data like this to make its investment decisions. It calls this strategy “upgrading,” an approach that it has been advocating in its newsletter since the 1970s.

The strategy looks at one-, three-, six- and 12-month fund returns. The belief, which began with Burt Berry, DAL’s founder, in the 1970s, was that market trends could not be forecast and were clear only in retrospect. But the trends lasted long enough so that you could capitalize on it. Call it the hot hand of investing.

DAL applied its strategy to the funds in this study, starting with the top 15 in 1989 and tracking their one-, three-, six- and 12-month returns. When a fund dropped out of the top third — below 99 — it sold the fund and reinvested the money in the top-ranked fund that it did not own.

DAL calls it “upgrading;” the academic literature typically calls it “casting out.”  Whatever you call it, our Systematic RS portfolios follow exactly the same process.  Sell it when the rank drops and replace it with the best-ranked item you don’t already own.  DAL used a composite measure of relative strength—as we’ve mentioned before, many methods will work as long as the portfolio gets exposed to the strong performers.

The article actually had a little broader mandate.  DAL looked at a range of funds for the New York Times to try to determine what worked and what didn’t.  Here’s what they found:

The best-performing funds over time were not necessarily the ones with the lowest fees, run by the best-known managers or focused on any particular strategy, according to more than 20 years of data examined by DAL Investments, an investment adviser and publisher of the NoLoad FundX newsletter in San Francisco. DAL analyzed the returns on 306 mutual funds for The New York Times.

Janet M. Brown, president of DAL Investments, said the deep dive was motivated as much by trying to figure out what worked as by testing the effectiveness of the firm’s own unconventional strategy. (More about that later.)

“The overall challenge of mutual fund investing is selecting funds in advance that people think will do well in the future,” Ms. Brown said. “The easiest thing would be to buy and hold or to select a manager with a good long-term track record and buy it and forget it. That was not an effective way of selecting funds.”

I added the bold.  It’s important because most investors select funds using exactly the process that DAL found ineffective!  (See Andy’s note on this same problem!)

What DAL found is that the funds that beat the benchmark changed over time.  As Ms. Brown said, “In my view, it has less to do with the brilliance of the portfolio manager as when their styles are in sync with the market,” she said.  This makes perfect sense.  Not one of the funds outperformed all the time.  In fact, the average fund lagged the benchmark one-third of the time.  Some funds lagged more years than they outperformed, but still had market-beating returns.  Other funds outperformed two-thirds of the time, but still fell behind the benchmark.

Because the styles that work keep changing, good portfolio management adapts.  That is one of the essential traits of relative strength: it does not discriminate and adapts to whatever is working.

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Cross This Approach Off Your List

January 3, 2012

Mark Hulbert, MarketWatch, shoots down a simple (yet apparently widely used!) approach to selecting managers:

Consider a hypothetical model portfolio that each year followed the model that had the best return in the previous calendar year, according to the Hulbert Financial Digest. Over 21 years through this past Dec. 31, this portfolio produced a 23.0% annualized loss.

For all intents and purposes, of course, that’s a complete and total wipeout.

Don’t conclude from this that you should instead follow the previous year’s worst performers. By doing that, you would perform even worse.

Consider a hypothetical portfolio that, instead of following the investment letter portfolio with the best returns in the previous calendar year, mimicked the portfolio that was the absolute worst performer. Believe it or not, this portfolio produced an annualized loss in excess of 50%.

A more in-depth approach to due diligence appears to be in order.

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Weekly RS Recap

January 3, 2012

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 (12/27/11 – 12/30/11) is as follows:

The top quartile outperformed the universe last week.

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