The Dorsey, Wright Technical Leaders Index is composed of a basket of 100 mid and large cap securities that have strong relative strength (momentum) characteristics. Each quarter we reconstitute the index by selling stocks that have underperformed and by adding new securities that score better in our ranking system. We began calculating the index in real-time at the end of 2006. Over the last seven years there have been quite a few deletions and additions as the index has adapted to some very dynamic market conditions.
Any relative strength or momentum-based investment strategy is a trend following strategy. Trend following has worked for many years in financial markets (although not every year). These systems are characterized by a several common attributes: 1) Losing trades are cut quickly and winners are allowed to run, 2) there are generally a lot of small losing trades, and 3) all of the money is made by the large outliers on the upside. When we look at the underlying trades inside of the index over the years we find exactly that pattern of results. There is a lot going on behind the scenes at each rebalance that is designed to eliminate losing positions quickly and maintain large allocations to the true winners that drive the returns.
We pulled constituent level data for the DWATL Index going back to the 12/31/2006 rebalance. For each security we calculated the return relative to the S&P 500 and how many consecutive quarters it was held in the index. (Note: stocks can be added, removed, and re-added to the index so any individual stock might have several entries in our data.) The table below shows summary statistics for all the trades inside of the index over the last seven years:
The data shows our underlying strategy is doing exactly what a trend following system is designed to accomplish. Stocks that aren’t held very long (1 to 2 quarters), on average, are underperforming trades. But when we are able to find a security that can be held for several quarters, those trades are outperformers on average. The whole goal of a relative strength process is to ruthlessly cut out losing positions and to replace them with positions that have better ranks. Any investor makes tons of mistakes, but the system we use to reconstitute the DWATL Index is very good at identifying our mistakes and taking care of them. At the same time, the process is also good at identifying winning positions and allowing them to remain in the index.
Here is the same data from the table shown graphically:
You can easily see the upward tilt to the data showing how relative performance on a trade-level basis improves with the time held in the index. For the last seven years, each additional consecutive quarter we have been able to keep a security in the Index has led to an average relative performance improvement of about 920 basis points. That should give you a pretty good idea about what drives the returns: the big multi-year winners.
We often speak to the overall performance of the Index, but we sometimes forget what is going on behind the scenes to generate that return. The process that is used to constitute the index has all of the characteristics of a trend following system. Underperforming positions are quickly removed and the big winning trades are allowed to remain in the index as long as they continue to outperform. It’s a lot like fishing: you just keep throwing the small ones back until you catch a large one. Sometimes it takes a couple of tries to get a keeper, but if you got a big fish on the first try all the time it would be called “catching” not “fishing.” I believe part of what has made this index so successful over the years is there is zero human bias that enters the reconstitution process. When a security needs to go, it goes. If it starts to perform well again, it comes back. It has no good or bad memories. There are just numbers.
The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses. Past performance is no guarantee of future returns. Potential for profit is accompanied by potential for loss. A list of all holdings for the trailing 12 months is available upon request.