I am a man of fixed and unbending principles, the first of which is to be flexible at all times. —Everett Dirksen
That statement encapsulates the paradox of relative strength investing—flexibility and discipline. In the financial markets, the word flexibility conjures up images of whimsical investment decisions with seemingly different rationale used for every trade. How different that is to the way that we invest at Dorsey Wright. We build models that typically have a great deal of flexibility, yet the rationale for every trades is the same—relative strength rank. We sell a current holding because its relative strength rank has fallen sufficiently and we buy a replacement position because of its favorable relative strength rank. In other words, we buy strong positions and we hold them for as long as they remain strong.
For example, one of the ETF models available through Dorsey Wright research is the DWA PowerShares Sector 4 Model (Power 4). This model is designed to gain exposure to the strongest relative strength sectors in the US through the use of the nine Sector Momentum ETFs: PYZ, PEZ, PSL, PXI, PFI, PTH, PRN, PTF, and PUI. When equities are not in favor, the portfolio can raise varying amounts of cash, up to 100%. Dorsey Wright is also the index provider for the 9 PowerShares Sector Momentum ETFs.
Power 4 Portfolio Rules
- Evaluated monthly
- An inventory is established to represent each of the nine macro sectors. The inventory consists of multiple representatives for each macro sector.
- A matrix is created to compare members of the inventory to one another.
- The sectors and cash are ranked from strongest to weakest based upon their tally rank within the matrix
- The top 4 sectors are equally weighted
- At the end of each month, if a sector falls out of the top 4, it is sold and replaced with the highest ranking sector not already in the portfolio.
- If cash is the #4 slot, it receives a weighting of 25%. For each slot it moves up, an additional 25% is allocated to cash. If cash is the #1 ranked asset class, it will receive a 100% weighting.
- Portfolio changes are transacted in a “replacement” method, and rebalanced only when a position drifts materially from it target allocation.
The start date for this model is 2/19/2014. We also tested the strategy back to 2002. Click here for a fact sheet.
Below you will see the historical allocations of the model:
Clearly, this is a flexible model. Yet, the rationale for each of the trades was the same: relative strength rank.
Any virtue, taken to an extreme, can become a vice. To be flexible is good, if it results in better investment results than a static allocation. However, if flexibility is taken to an extreme, it can lead to overtrading and poor investment results. Likewise, discipline is good, but if it results in an inability to adapt to different market environments, it can become a vice.
In the models we build at Dorsey Wright, we make great efforts to find a healthy way to have both flexibility and discipline.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Nothing contained herein should be construed as an offer to sell or the solicitation of an offer to buy any security. This post does not attempt to examine all the facts and circumstances which may be relevant to any product or security mentioned herein. We are not soliciting any action based on this post. It is for the general information of readers of this blog. This post 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 post, investors should consider whether the security or strategy in question is suitable for their particular circumstances and, if necessary, seek professional advice. Dorsey Wright & Associates is the index provider for the suite of PowerShares DWA Momentum ETFs. Some of the performance information is the result of back-tested performance. Back-tested performance is hypothetical (it does not reflect trading in actual accounts) and is provided for informational purposes to illustrate the effects of the relative strength strategy during a specific period. Back-tested performance results have certain limitations. Back-testing performance differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with teh benefit of hindsight. model performance data does not represent the impact of material economic and market factors might have on an invesment advisor’s decision making process if the advisor were actually managing client money.