Retirement Success

April 30, 2013

Financial Advisor had a recent article in which they discussed a retirement success study conducted by Putnam.  Quite logically, Putnam defined retirement success by being able to replace your income in retirement. They discovered three keys to retirement success:

  1. Working with a financial advisor
  2. Having access to an employer-sponsored retirement plan
  3. Being dedicated to personal savings

None of these things is particularly shocking, but taken together, they illustrate a pretty clear path to retirement success.

  • Investors who work with a financial advisor are on track to replace 80 percent of their income in retirement, Putnam says. Those who do not are on track to replace 56 percent.
  • Workers who are eligible for a workplace plan are on track to replace 73 percent of their income while those without access replace only 41 percent.
  • The ability to replace income in retirement is not tied to income level but rather to savings level, Putnam says. Those families that save 10 percent or more of their income, no matter what the income level, are on track to replace 106 percent of their income in retirement, which underscores the importance of consistent savings, the study says.

I added the bold.  It’s encouraging that retirement success is tied to savings level, not income level.  Everyone has a chance to succeed in retirement if they are willing to save and invest wisely.  It’s not just an opportunity restricted to top earners.  Although having a retirement plan at work is very convenient, you can still save on your own.

It’s also interesting to me how much working with a financial advisor can increase the ability to replace income in retirement.  Maybe advisors are helping clients invest more wisely, or maybe they are just nagging them to save more.  Whatever the combination of factors, it’s clearly making a big difference.  Given that the average income replacement level found in the study was 61%, working with an advisor moved clients from below average (56%) to well above average (80%) success.

This study, like pretty much every other study of retirement success, also shows that nothing trumps savings.  After all, no amount of clever investment management can help you if you have no capital to work with.  For investors, Savings is Job One.

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Relative Strength Spread

April 30, 2013

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 4/29/2013:

spread 04.30.13

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Weekly RS Recap

April 29, 2013

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile 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 (4/22/13 – 4/26/13) is as follows:

ranks 04.29.13

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Client Sentiment Survey 4/26/13

April 26, 2013

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

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Relative Strength International Dividend UIT

April 26, 2013

First Trust just published the fact sheet for the newly launched Dorsey Wright Relative Strength International Dividend UIT.  Click below for the fact sheet.

intl div uit

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Sector and Capitalization Performance

April 26, 2013

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 4/25/2013.

s_c 04.26.13

Numbers shown are price returns only and are not inclusive of transaction costs.  Source: iShares

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Fund Flows

April 25, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 04.25.13

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Client Sentiment Survey Results – 4/12/13

April 23, 2013

Our latest sentiment survey was open from 4/12/13 to 4/19/13.  The Dorsey, Wright Polo Shirt Raffle continues to drive advisor participation, and we greatly appreciate your support!  This round, we had 57 advisors participate in the survey. If you believe, as we do, that markets are driven by supply and demand, client behavior is important.  We’re not asking what you think of the market—since most of our blog readers are financial advisors, we’re asking instead about the behavior of your clients.  Then we’re aggregating responses exclusively for our readership.  Your privacy will not be compromised in any way.

After the first 30 or so responses, the established pattern was simply magnified, so we are fairly comfortable about the statistical validity of our sample. Some statistical uncertainty this round comes from the fact that we only had four investors say that thier clients are more afraid of missing a stock upturn than being caught in a downdraft. Most of the responses were from the U.S., but we also had multiple advisors respond from at least two other countries. Let’s get down to an analysis of the data! Note: You can click on any of the charts to enlarge them.

Question 1. Based on their behavior, are your clients currently more afraid of: a) getting caught in a stock market downdraft, or b) missing a stock market upturn?

Chart 1: Greatest Fear.  From survey to survey, the S&P 500 rose slightly, and none of our indicators worked correctly.  This has to do with when we publish the survey (Friday) and when most people take the survey (Monday).  On that Monday, the S&P had a big down day and these results incorporate that move down.  The fear of downturn group rose from 71% to 74%.  The fear of missing upturn group fell from 29% to 26%.

Chart 2: Greatest Fear Spread. Another way to look at this data is to examine the spread between the two groups.  The spread rose from 42% to 47%.

Question 2. Based on their behavior, how would you rate your clients’ current appetite for risk?

Chart 3: Average Risk Appetite.  Average risk appetite dropped this round, from 3.08 to 2.85.

Chart 4: Risk Appetite Bell Curve.  This chart uses a bell curve to break out the percentage of respondents at each risk appetite level.  This round, over 50% of all respondents wanted a risk appetite of 3.

Chart 5: Risk appetite Bell Curve by Group.  The next three charts use cross-sectional data.  The chat plots the reported client risk appetite separately for the fear of downdraft and for the fear of missing upturn groups.  We can see the upturn group wants more risk, while the fear of downturn group is looking for less risk.

Chart 6: Average Risk Appetite by Group.  This round, both groups’ risk appetite fell lower.

Chart 7: Risk Appetite Spread.  This is a chart constructed from the data in Chart 6, where the average risk appetite of the downdraft group is subtracted from the average risk appetite of the missing upturn group.  The spread dropped this round.

From survey to survey, the S&P rose slightly.  However, the market fell steeply when most of our respondents were taking the survey, as evidenced by a sharp pullback in client sentiment.  All of the indicators showed a marked decrease in client sentiment.  However, this is to be expected somewhat, considering how great the first quarter was.  Let’s hope for a small pullback and a continued rally into spring.

No one can predict the future, as we all know, so instead of prognosticating, we will sit back and enjoy the ride.  A rigorously tested, systematic investment process provides a great deal of comfort for clients during these types of fearful, highly uncertain market environments.  Until next time, good trading and thank you for participating.

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Relative Strength Spread

April 23, 2013

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 4/22/2013:

RS Spread

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Tale of Two Emerging Markets ETFs

April 22, 2013

It’s almost hard to believe that these are both Emerging Markets ETFs given the huge difference in performance YTD.

emg mkts

Source: Yahoo! Finance

Our overweights and underweights have really paid off so far this year:

pie1

 

Please see www.powershares.com for more information.  Performance numbers listed above are pure price returns, not inclusive of dividends, all fees, or other expenses.  Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.

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Weekly RS Recap

April 22, 2013

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile 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 (4/15/13 – 4/19/13) is as follows:

ranks 04.22.13

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Podcast #28 The Appeal of Smart Beta

April 19, 2013

Podcast #28 The Appeal of Smart Beta

Mike Moody and Andy Hyer

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Sector and Capitalization Performance

April 19, 2013

The chart below shows performance of US sectors and capitalizations over the trailing 12, 6, and 1 month(s).  Performance updated through 4/18/2013.

s_c 4.19.13

Numbers shown are price returns only and are not inclusive of transaction costs.  Source: iShares

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The Wonders of Momentum

April 18, 2013

Relative strength investors will be glad to know that James Picerno’s Capital Spectator blog has an article on the wonders of momentum.  He discusses the momentum “anomaly” and its history briefly:

Momentum is one of the oldest and most persistent anomalies in the financial literature. The tendency of positive or negative returns to persist for a time seems like a ridiculously simple predictor, but it works. There’s an ongoing debate about why it works, but the results in numerous tests speak loud and clear. Unlike many (most?) reported sources of alpha, the market-beating and risk-lowering results linked to momentum strategies appear to be immune to arbitrage.

Informally, it’s fair to say that investors have been exploiting momentum in various forms for as long as humans have been trading assets. Formally, the concept dates to at least 1937, when Alfred Cowles and Herbert Jones reviewed momentum in their paper “Some A Priori Probabilities in Stock Market Action.” In the 21st century, an inquiring reader can easily find hundreds of papers on the subject, most of it published in the wake of Jegadeesh and Titman’s seminal 1993 work: “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” which marks the launch of the modern age of momentum research.

I think his observation that momentum (relative strength to us) has been around since humans have been trading assets is spot on.  It’s important to keep that in mind when thinking about why relative strength works—and why it has been immune to arbitrage.  He writes:

Momentum, it seems, is one of the rare risk factors with features that elude so many other strategies: It’s persistent, conceptually straightforward, robust across asset classes, and relatively easy to implement. It’s hardly a silver bullet, but nothing else is either.

The only mystery: Why are we still talking about this factor in glowing terms? We still don’t have a good answer to explain why this anomaly hasn’t been arbitraged away, or why it’s unlikely to meet an untimely demise anytime soon.

Mr. Picerno raises a couple of important points here.  Relative strength does have a lot of attractive features.  The reason it is not a silver bullet is that it underperforms severely from time to time.  Although that is also true of other strategies, I think the periodic underperformance is one of the reasons why the excess returns have not been arbitraged away.

Although he suggests we don’t have a good answer about why momentum works, I’d like to offer my explanation.  I don’t know if it’s a good answer or not, but it’s what I’ve arrived at after years of research and working with relative strength portfolios—not to mention a degree in psychology and a couple of decades of seeing real investors operate in the market laboratory.

  • Relative strength straddles both fundamental analysis and behavioral finance.
  • High relative strength securities or assets are generally strong because they are undergoing fundamental improvement or are in a sweet spot for fundamentals.  In other words, if oil prices are trending strongly higher, it’s not surprising that certain energy stocks are strong.  That’s to be expected from the fundamentals.  Often there is improvement at the margin, perhaps in revenue growth or operating margin—and that improvement is often underestimated by analysts.  (Research shows that investors are more responsive to changes at the margin than to the absolute level of fundamental factors.  For example, while Apple’s operating margin grew from 2.2% in 2003 to 37.4% in 2012, the stock performed beautifully.  Even though the operating margin is expected to be in the 35% range this year—which is an extremely high level—the stock is getting punished.  Valero’s stock price plummeted when margins went from 10.0% in 2006 to 2.4% in 2009, but has doubled off the low as margins rebounded to 4.8% in 2012.  Apple’s operating margin on an absolute basis is drastically higher than Valero’s, but the delta is going the wrong way.)  High P/E multiples can often be maintained as long as margin improvement continues, and relative strength tends to take advantage of that trend.  Often these trends persist much longer than investors expect.
  • From the behavioral finance side, social proof helps reinforce relative strength.  Investors herd and they gravitate toward what is already in motion, and that reinforces the price movement.  They are attracted to the popular and repelled by the unpopular.
  • Periodic bouts of underperformance help keep the excess returns of relative strength high.  When momentum goes the wrong way it can be ugly.  Perhaps margins begin to contract and financial results are worse than analysts expect.  The security has been rewarded with a high P/E multiple, which now begins to unwind.  The herd of investors begins to stampede away, just as they piled in when things were going well.  Momentum can be volatile and investors hate volatility.  Stretches of underperformance are psychologically painful and the unwillingness to bear pain (or appropriately manage risk) discourages investors from arbitraging the excess returns away.

In short, I think there are multiple reasons why relative strength works and why it is difficult to arbitrage away the excess returns.  Those reasons are both fundamental and behavioral and I suspect will defy easy categorization.  Judging from my morning newspaper, human nature doesn’t change much.  Until it does, markets are likely to work the same way they always have—and relative strength is likely to continue to be a powerful return factor.

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Fund Flows

April 18, 2013

Mutual fund flow estimates are derived from data collected by The Investment Company Institute covering more than 95 percent of industry assets and are adjusted to represent industry totals.

ici 04.18.13

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Nate Silver Interview

April 17, 2013

Here’s a link to a nice Nate Silver interview at Index Universe.  Nate Silver is now a celebrity statistician due to his accurate election forecasts, although he started by doing statistics for baseball.  In the interview, he discusses some of the ways that predictions can go wrong.  In general, human beings are completely wrong about the stock market!

The typical retail investor frankly does things exactly wrong—they tend to buy at the top and sell at the bottom. Theoretically, you make this long-run average return, but a lot of people are buying at the market peaks. For many years, the Gallup Poll has periodically been asking investors whether it’s a good time to invest or not. There’s a strong historical negative correlation between when people think it’s a good time to invest and the five- or 10-year returns on the S&P 500.

Overconfidence can also kill predictions.  Other studies have found that the more confident the forecaster the worse the forecast tends to be, something that makes watching articulate bulls and bears on CNBC particularly dangerous!

It’s worth a read.

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High RS Diffusion Index

April 17, 2013

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 4/16/13.

diffusion 04.17.13

The 10-day moving average of this indicator is 74% and the one-day reading is 68%.

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DWA Technical Leaders Webinar Replay

April 16, 2013

Click below to access.

dwa

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Relative Strength Spread

April 16, 2013

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks).  When the chart is rising, relative strength leaders are performing better than relative strength laggards.    As of 4/15/2013:

spread 04.16.13

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Gold: Getting Personal

April 15, 2013

Interesting chart of the S&P vs. gold going back a few decades:

SP_Gold

Joe Weisenthal’s take:

You can see that even with the recent upturn in stocks, relative to gold, gold has crushed stocks since 2000.

Arguably, 2000 represented a peak in belief in the capabilities of humans. The internet inspired all kinds of crazy optimism about how humans would re-shape the world for the better. The ebullience spread beyond the net. There was, for example, optimism about newways of transporting humans: Fuel cells! Segway!

Of course, the bubble crashed. Then we had 9/11. Then we had two wars. Then we had the housing implosion. Then we had the financial crisis. Then the horrible recession. Then the European crisis and the debt ceiling and everything else.

In other words, we had a series of a events that, for good reason, shook our faith in humanity. During this time, people thought about history on a large scale. And gold, having been used as a money for thousands of years, did pretty well, especially relative to stocks, which represent companies made up of humans.

So ultimately, the decline of gold and the rise of stocks is a big trend that everyone should cheer.

The huge corpus of economic research, which has informed the US’ efforts to stimulate the economy, is not a pile of garbage. You can do a lot without blowing things up, as the goldbugs claimed would happen.

And more broadly, this represents a breaking of the fever, and perhaps a return to thinking that humans aren’t such a horrible disappointment.

With gold’s recent declines, analysis such as that written by Weisenthal is all over the place.  Gold really gets personal with people.  For many, its strength or weakness has the ability to validate their economic and political views.

From a strictly trend following perspective, the S&P vs. gold relative strength relationship is potentially significant because of its history of providing long-term trends favoring one or the other.  If this ultimately does result in a major inflection point for the S&P vs. gold relationship, there will be important implications for those of us employing tactical asset allocation strategies in the years ahead.  Admittedly, simply observing the relative strength relationship between the two provides much less intrigue than can be found on talk radio or any number of other sources (but that can be a very good thing for investors who are just looking to make money).

HT: Business Insider

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Weekly RS Recap

April 15, 2013

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 (4/8/13 – 4/12/13) is as follows:

ranks 04.15.13

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Current Income

April 12, 2013

Investors lately are in a frenzy about current income.  With interest rates so low, it’s tough for investors, especially those nearing or already in retirement, to come up with enough current income to live on.  A recent article in Advisor Perspectives had a really interesting take on current income.  The author constructed a chart to show how much money you would have to invest in various asset classes to “buy” $100,000 in income.  Some of these asset classes might also be expected to produce capital gains and losses, but this chart is purely based on their current income generation ability.  You can read the full original article to see exactly which asset classes were used, but the visual evidence is stunning.

Source: Advisor Perspectives/Pioneer Investments (click to enlarge)

There are two things that I think are important to recognize—and it’s hard not to with this chart.

  1. Short-term interest rates are incredibly low, especially for bonds presumed to have low credit risk.  The days of rolling CDs or clipping a few bond coupons as an adequate supplement to Social Security are gone.
  2. In absolute terms, all of these amounts are relatively high.  I can remember customers turning up their noses at 10% investment-grade tax-exempt bonds—they felt rates were sure to go higher—but it only takes a $1 million nest egg to generate a $100,000 income at that yield.  Now, it would take more than $1.6 million, even if you were willing to pile 100% into junk bonds.  (And we all know that more money has been lost reaching for yield than at the point of a gun.)  A more realistic guess for the typical volatility tolerance of an average 60/40 balanced fund investor is probably something closer to $4.2 million.  Even stocks aren’t super cheap, although they seem to be a bargain relative to short-term bonds.

That’s daunting math for the typical near-retiree.  Getting anywhere close to that would require compounding significant savings for a long, long time—not to mention remarkable investment savvy.  The typical advisor has only a handful of accounts that large, suggesting that much work remains to be done educating clients about savings, investment, and the reality of low current yields.

The pressure for current income might also entail some re-thinking of the entire investment process.  Investors may need to focus more on total return, and realize that some capital gains can be spent as readily as dividends and interest.  Relative strength may prove to be a useful discipline in the search for returns, wherever they may be found.

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The Problem With Intrinsic Value

April 12, 2013

Howard Marks makes a compelling argument for using relative strength (without even referring to relative strength):

“If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).

“I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

“…I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.”

Buyers and sellers respond to the very same fundamental factors in very different ways depending on the environment.  A stock can be cheap (and get cheaper) for a long period of time until which time as there are more buyers than sellers and the price begins to rise.  Relative strength doesn’t even make an attempt to estimate intrinsic value.  To a relative strength strategy, the concept of intrinsic value is meaningless.  A security is worth whatever the market says it’s worth.  Relative strength models simply allocate to the strongest trends in the market and therefore avoid the potential problems of sitting around waiting for the market to come around to your way of thinking.

As Marks correctly points out, the world changes radically over time.  However, one constant is the law of supply and demand.

HT: Business Insider

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Client Sentiment Survey – 4/12/13

April 12, 2013

Here we have the next round of the Dorsey, Wright Sentiment Survey, the first third-party sentiment poll.  Participate to learn more about our Dorsey, Wright Polo Shirt raffle! Just follow the instructions after taking the poll, and we’ll enter you in the contest.  Thanks to all our participants from last round.

As you know, when individuals self-report, they are always taller and more beautiful than when outside observers report their perceptions!  Instead of asking individual investors to self-report whether they are bullish or bearish, we’d like financial advisors to weigh in and report on the actual behavior of clients.  It’s two simple questions and will take no more than 20 seconds of your time. We’ll construct indicators from the data and report the results regularly on our blog–but we need your help to get a large statistical sample!

Click here to take Dorsey, Wright’s Client Sentiment Survey.

Contribute to the greater good!  It’s painless, we promise.

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Investment Manager Selection

April 12, 2013

Investment manager selection is one of several challenges that an investor faces.  However, if manager selection is done well, an investor has only to sit patiently and let the manager’s process work—not that sitting patiently is necessarily easy!  If manager selection is done poorly, performance is likely to be disappointing.

For some guidance on investment manager selection, let’s turn to a recent article in Advisor Perspectives by C. Thomas Howard of AthenaInvest.  AthenaInvest has developed a statistically validated method to forecast fund performance.  You can (and should) read the whole article for details, but good investment manager selection boils down to:

  • investment strategy
  • strategy consistency
  • strategy conviction

This particular article doesn’t dwell on investment strategy, but obviously the investment strategy has to be sound.  Relative strength would certainly qualify based on historical research, as would a variety of other return factors.  (We particularly like low-volatility and deep value, as they combine well with relative strength in a portfolio context.)

Strategy consistency is just what it says—the manager pursues their chosen strategy without deviation.  You don’t want your value manager piling into growth stocks because they are in a performance trough for value stocks (see Exhibit 1999-2000).  Whatever their chosen strategy or return factor is, you want the manager to devote all their resources and expertise to it.  As an example, every one of our portfolio strategies is based on relative strength.  At a different shop, they might be focused on low-volatility or small-cap growth or value, but the lesson is the same—managers that pursue their strategy with single-minded consistency do better.

Strategy conviction is somewhat related to active share.  In general, investment managers that are willing to run relatively concentrated portfolios do better.  If there are 250 names in your portfolio, you might be running a closet index fund.  (Our separate accounts, for example, typically have 20-25 positions.)  A widely dispersed portfolio doesn’t show a lot of conviction in your chosen strategy.  Of course, the more concentrated your portfolio, the more it will deviate from the market.  For managers, career risk is one of the costs of strategy conviction.  For investors, concentrated portfolios require patience and conviction too.  There will be a lot of deviation from the market, and it won’t always be positive.  Investors should take care to select an investment manager that uses a strategy the investor really believes in.

AthenaInvest actually rates mutual funds based on their strategy consistency and conviction, and the statistical results are striking:

The  higher the DR [Diamond Rating], the more likely it will outperform in the future. The superior  performance of higher rated funds is evident in Table 1. DR5 funds outperform DR1 funds by more than  5% annually, based on one-year subsequent returns, and they continue to deliver  outperformance up to five years after the initial rating was assigned. In this  fashion, DR1 and DR2 funds underperform the market, DR3 funds perform at the  market, and DR4 and DR5 funds outperform. The average fund matches market  performance over the entire time period, consistent with results reported by  Bollen and Busse (2004), Brown and Goetzmann (1995) and Fama and French  (2010), among others.

Thus,  strategy consistency and conviction are predictive of future fund performance  for up to five years after the rating is assigned.

The bold is mine, as I find this remarkable!

I’ve reproduced a table from the article below.  You can see that the magnitude of the outperformance is nothing to sniff at—400 to 500 basis points annually over a multi-year period.

Source: Advisor Perspectives/AthenaInvest   (click on image to enlarge)

The indexing crowd is always indignant at this point, often shouting their mantra that “active managers don’t outperform!”  I regret to inform them that their mantra is false, because it is incomplete.  What they mean to say, if they are interested in accuracy, is that “in aggregate, active managers don’t outperform.”  That much is true.  But that doesn’t mean you can’t locate active managers with a high likelihood of outperformance, because, in fact, Tom Howard just demonstrated one way to do it.  The “active managers don’t outperform” meme is based on a flawed experimental design.  I tried to make this clear in another blog post with an analogy:

Although I am still 6’5″, I can no longer dunk a basketball like I could in college.  I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either.  If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky?  Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense?  If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?

In other words, if you look for the right characteristics, you have a shot at finding winning investment managers too.  This is valuable information.  Think of how investment manager selection is typically done:  “What was your return last year, last three years, last five years, etc.?”  (I know some readers are already squawking, but the research literature shows clearly that flows follow returns pretty closely.  Most “rigorous due diligence” processes are a sham—and, unfortunately, research shows that trailing returns alone are not predictive.)  Instead of focusing on trailing returns, investors would do better to locate robust strategies and then evaluate managers on their level of consistency and conviction.

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