Embracing Tracking Error

February 23, 2012

One characteristic of relative strength strategies is that they rarely track their benchmarks–and for good reason because they are designed to overweight areas with strong relative strength and underweight areas with weak relative strength. The goal of this approach is to capitalize on long-term trends and it works well over time. In environments with strong trends in place we tend to see outperformance and in environments with major leadership changes or choppy markets we tend to see underperformance.

In the case of the Arrow DWA Balanced Fund (DWAFX), the highlighted row below shows that we outperformed nearly all of our peers in 2007 and 2010; outperformed 74 percent of our peers in 2008; and underperformed the vast majority of our peers in 2009 and 2011. So far in 2012, we are right in the middle of the pack. Yet, over the past five years we have outperformed 66% of our peers.

Source: Morningstar

Those investors who understand and accept the fact that relative strength strategies won’t track a benchmark much of the time are in a much better position to reap the rewards that accrue to disciplined investors.

Dorsey Wright sub-advises The Arrow DWA Balanced Fund. Please click here for more information.

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More on Buckets

February 23, 2012

From an article at AdvisorOne, a discussion of the advantages and disadvantages of buckets versus systematic withdrawals:

The bucket approach offers the client a greater feeling of self-control. “For retirees feeling overwhelmed by the many decisions they face as they enter retirement, a bucket strategy may help them divide what they see as one large, stress-inducing problem into smaller, more manageable pieces,” the analysis states.

The article references a paper done by Principal Financial, which goes into more depth.

According to an AARP study, the majority of people fear running out of money in retirement more than they fear death. It’s no wonder many people look to financial professionals for help as they enter retirement. While working with a financial professional on any type of retirement income strategy can help a retiree feel more confident in his or her plan, research has shown that the bucket strategy may provide some additional psychological benefits. A bucket strategy can address a human preference for smaller, simplified issues. For retirees feeling overwhelmed by the many decisions they face as they enter retirement, a bucket strategy may help them divide what they see as one large, stress-inducing problem into smaller, more manageable pieces. A bucket strategy that links portions of money directly to goals may also promote self-control.

The paper is well worth reading, although I have some reservations about it. It makes a number of assumptions about how the bucket strategy is to be carried out and then tries to make a comparison with systematic withdrawals from a target date fund. Suffice it to say that a glide path that holds more and more bonds as you age (and are more exposed to inflation) may not be an ideal solution. In addition, I’ve written before that there is no necessary functional difference between a balanced account and a portfolio using buckets. You can have the same allocation in both—it’s just a matter of controlling investor psychology.

In reality, most investment performance problems are investor behavior problems. To the extent that a bucket approach can mitigate that for a client, I say to go for it.

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Fund Flows

February 23, 2012

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.

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