Systematic Relative Strength

Why relative strength?

Longboard Asset Management completed a study called The Capitalism Distribution that examined stock returns from the top 3000 stocks from 1983-2007. They found that:

-39% of stocks were unprofitable investments.

-19% of stocks lost at least 75% of their value.

-64% of stocks underperformed the index.

-25% of stocks were responsible for all the market’s gains.

Simply picking a stock out of a hat means you have a 64% chance of underperforming a basic index fund, and roughly a 40% chance of losing money!

Luckily, investors don’t need to picks stocks out of a hat and hope they get lucky in order to find the winners. Relative strength provides an effective framework for building a portfolio of winners and capitalizing on long term trends. Click here to read Relative Strength and Portfolio Management by John Lewis to see the results of relative strength tests on U.S. equities over a 16 year period. As summarized in the paper:

Relative strength and momentum strategies have delivered market-beating returns for many years. There has been a great deal of research in this area by both practitioners and academics. However, despite this public disclosure of information, these strategies continue to outperform over time. Many of the testing methodologies used over the years are not consistent with real-world portfolio construction and do not address the possible range of outcomes when implementing a relative strength strategy. Our continuous, Monte Carlo testing process corrects for both of these deficiencies. Similar to other research, our process shows simple relative strength factors to be extremely robust over intermediate horizon formation periods, and weak over very short-term and long-term horizons. We also find there can be great variation in portfolio returns over short time periods, but over long holding periods the portfolios perform exceptionally well.

HT: Mebane Faber Research

Our partners at Arrow Funds have recently published some relative strength research that should be essential reading for any advisor who is looking to provide value to their clients. Relative Strength Turns provides important insights into the cyclical nature of relative strength performance and makes a compelling case why now may be a great time to be allocating to relative strength strategies.

Historically, over very long periods of time, each of these relative strength models outperforms a buy-and-hold equity model. However, like many investment approaches, relative strength will sometimes underperform the market, and at other times it may outperform. This comparative performance, also known as RS Alpha, can be cyclical resulting in long-term trends with significant tops followed by underperformance and bottoms folloed by outperformance, as the chart below illustrates.

When the trend turns upward, it starts long periods of time when relative strength performance above the historical average.

The normal course of business in this industry is for fund companies to pound the table on a strategy or return factor that has already had an extended run of outperformance. Arrow Funds has taken a different approach with this research. Using historical data, they make a solid case for why relative strength is a winning long-term return factor and why the opportunity to enter relative strength strategies now may be particularly profitable.

Click below to read the entire piece.

Past performance is no guarantee of future returns. Click here for disclosures.