Systematic Relative Strength

Morgan Housel recently shared an excellent way to think about one of the biggest challenges facing investors—failure to think outside their own viewpoint:

Statistics genius Nate Silver spoke at a conference in Seattle a few weeks ago. He made a point that stuck with me. Radar technology was in its infancy in the early 1940s. To protect U.S. interests like the Pacific Fleet in Pearl Harbor, Navy planes circled the Hawaiian Islands, searching for threats. “You were just sending a couple of planes that would go around a circumference until they ran out of fuel and then head back to base,” Silver said.

Alas, the Japanese military knew exactly how large that circumference was, and in November, 1941, sent its aircraft carriers just beyond the range our reconnaissance planes could fly. On December 7th, it attacked.

“My point is that everyone has a viewpoint,” Silver said, and that viewpoint usually shows just a fraction of the whole picture. There are important events sitting outside your viewpoint that, if you knew about them, would totally change how you view the world.

There’s a similar problem with investors and history. Your view of history is heavily influenced by your own experiences. But just like the Navy, your own experiences are an incomplete view of the world, arbitrarily blocked by when and where you were born — the equivalent of reconnaissance planes with limited fuel range. There are important events sitting outside your viewpoint that, if you experienced them, would totally change how you view the world.

This has important implications for how to design an asset allocation. If one looks at too narrow a slice of history when determining the exposure constraints for different asset classes an investor could easily optimize those constraints to fit just that last 20 or 30 years. Depending on what 20 or 30 year period you look at you may wish you had more exposure to U.S. equities, International equities, Inverse Equities, Currencies, Commodities, Real Estate, or Fixed Income. Since none of us have a crystal ball to know which asset classes will be most rewarding over the next 20-30 years, it makes sense to maintain flexibility. This is precisely the reason that we have given ourselves so much flexibility in The Arrow DWA Tactical Fund (DWTFX), which we sub-advise.

The Arrow DWA Tactical Fund (DWTFX) invests in various asset classes and market segments exhibiting positive relative strength. In essence, the model works by reallocating to various market segments in response to the changing patterns of returns available in the global markets. The table below shows the Fund’s potential allocation ranges.

Source: Arrow Funds

Investors may greatly benefit by not painting themselves into a corner when it comes to asset allocation.

A relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. See www.arrowfunds.com for a prospectus for DWTFX.

Systematic RS Global Macro Strategy

Frequently Asked Questions

What is the investment objective of the strategy? The strategy seeks to achieve meaningful risk diversification and investment returns. The historical correlation of this strategy to every major asset class has been relatively low over time. Our global macro strategy is uniquely positioned from an investment opportunity perspective because it is not limited to a specific market.

What asset classes are represented in the strategy? The strategy is designed to invest in the following asset classes: Domestic Equities (long & inverse), International Equities (long & inverse), Fixed Income, Real Estate, Currencies, and Commodities. Exposure to each of these areas is achieved through ETFs.

How are the investments selected? The strategy holds approximately ten ETFs that demonstrate powerful relative strength characteristics. The strategy is constructed pursuant to Dorsey Wright’s proprietary basket ranking and rotation methodology.

How is this different from strategic asset-allocation? We do not approach the asset allocation from a strategic standpoint. Instead, we implement a tactical approach. Our tactical overlay is designed to own the areas of the market exhibiting the greatest relative performance and avoid or use inverse funds for the weakest areas. You can expect the weightings to change over time! When, for example, domestic equities are performing poorly our tactical process will avoid or use inverse funds in these areas or favor an area with better relative performance, like fixed income. We make changes to the investment mix as markets and leadership change. The portfolio is designed to be quite responsive to emerging strength.

How do all these processes come together? The investment strategy is 100% systematic. We have designed our processes to remove the portfolio managers’ emotions and biases, which are detrimental to superior long-term performance.

How is risk managed in the portfolio? Our investment process is designed to systematically rotate the portfolio into the strongest asset classes and individual alternatives within those asset classes. If an asset class is performing poorly the tactical asset allocation overlay will avoid or use inverse funds in that area and buy an asset class with better relative strength. There is a stop, based on the relative strength ranking, on each holding. The asset classes used in the portfolio are not typically highly correlated, so that our investment guidelines provide enough latitude to deliver solid returns in a variety of market conditions.

Will the portfolio ever go to cash? Our investment universe includes ETFs that represent the shorter-term sector of the United States Treasury market. So, yes, we can effectively allocate a portion of the account to cash if that is where the best relative strength is found.

What is the average annual turnover? The portfolio is designed to rapidly adapt to changing market conditions. As a result, there might be more realized gains and losses during periods when asset class leadership is changing, and fewer realized gains and losses when there is stable leadership. The average annual turnover has been approximately 250% over time. With 10 positions in the portfolio, that represents an average of 25 swaps per year.

What is an ETF? An exchange-traded fund is an investment vehicle traded on a stock exchange, much like a stock. ETFs offer public investors an undivided interest in a pool of securities and other assets and thus are similar in many ways to traditional mutual funds. An ETF holds assets such as stocks, bonds, currencies, commodities, or futures contracts on commodities and trades at approximately the same price as the net asset value of its underlying assets over the course of the trading day. ETFs are attractive investments because of their low costs, tax efficiency, and stock-like features.

Will you be investing in all of the ETFs? We have a rigorous process to determine what ETFs we will evaluate for our portfolios. There are many ETFs that are duplicative or not suitable for the investment strategy we are using in this portfolio, and we do not consider these for purchase in the fund. As new ETFs come to market we are committed to evaluating their investment merits and the effect they might have on our investment strategy. Any new ETFs will need to meet the same stringent criteria as existing ETFs for consideration in the portfolio.

For more information about this strategy, please e-mail [email protected].

Nothing contained herein should be construed as an offer to sell or the solicitation of an offer to buy any se­curity. This report does not attempt to examine all the facts and circumstances which may be relevant to any company, industry or security mentioned herein. We are not soliciting any action based on this document. It is for the general information of clients of Dorsey, Wright & Associates, LLC (“Dorsey, Wright & Associates”). This document does not constitute a personal recommendation or take into account the particular investment objectives, financial situations, or needs of individual clients. Before acting on any analysis, advice or recommendation in this document, clients should consider whether the security or strategy in question is suitable for their particular circumstances and, if neces­sary, seek professional advice.

The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.

Each investor should carefully consider the investment objectives, risks and expenses of any Exchange-Traded Fund (“ETF”) prior to investing. Before investing in an ETF investors should obtain and carefully read the relevant prospectus and documents the issuer has filed with the SEC. To obtain more complete information about the product the documents are publicly available for free via EDGAR on the SEC website (http://www.sec.gov).

4/30/2014

The Arrow DWA Balanced Fund (DWAFX)

At the end of April, the fund had approximately 45% in U.S. Equities, 25% in Fixed Income, 18% in International Equities, and 12% in Alternatives.

After a number of allocation changes in March, the fund had no changes in April. One of the asset classes with the most changes in 2014 has been alternatives—commodities and real estate have been particularly strong after being quite weak in 2013. Our position in MLP’s was our best performing holding in April. We also generally had good performance from our European equity positions. Interest rates fell in April, helping bonds also produce some positive gains. The weakness in April came from our U.S. equity exposure—particularly our small cap exposure. While 2013 tended to favor more concentrated asset allocation strategies, 2014 has been a year with more cross-currents and diversified asset allocation strategies, like this one, have been able to dampen much of the volatility.

DWAFX lost 0.20% in April, but is up 0.34% YTD through 4/30/14.

We believe that a real strength of this strategy is its balance between remaining diversified, while also adapting to market leadership. When an asset class is weak its exposure will tend to be towards the lower end of the exposure constraints, and when an asset class is strong its exposure in the fund will trend toward the upper end of its exposure constraints. Relative strength provides an effective means of determining the appropriate weights of the strategy.

The Arrow DWA Tactical Fund (DWTFX)

At the end of April, the fund had approximately 90% in U.S. equities and 9% in International equities.

One of the dominant themes in 2013 was the outperformance of U.S. small cap stocks. DWTFX had a lot of exposure to small caps last year and this was part of the reason that the fund performed well in 2013. That trend continued through February of this year, but in March and April we have seen sharp underperformance of small caps. While our buy and sell criteria for the fund are not based on short-term relative strength signals, small caps have dropped in our ranks and if this trend continues it is likely that we will see some changes to the fund in the coming weeks. Our European equity exposure was a bright spot for the fund in April as it added to its gains for the year. Asset classes like commodities and real estate continue to see improvement and, if it continues, may be areas where we add exposure in the coming weeks.

DWTFX lost 0.96% in April, but is up 0.19% YTD through 4/30/14.

This strategy is a go-anywhere strategy with very few constraints in terms of exposure to different asset classes. The strategy can invest in domestic equities, international equities, inverse equities, currencies, commodities, real estate, and fixed income. Market history clearly shows that asset classes go through secular bull and bear markets and we believe this strategy is ideally designed to capitalize on those trends. Additionally, we believe that this strategy can provide important risk diversification for a client’s overall portfolio.

A list of all holdings for the trailing 12 months is available upon request. Past performance is no guarantee of future returns. See www.arrowfunds.com for a prospectus.