As the Smart Beta movement marches on, one of the questions that frequently comes up from advisors is how Smart Beta strategies fit in an asset allocation. Should they be viewed as a strategic (i.e. buy and hold) portion of an allocation, or should they be viewed as a tactical (i.e. shorter-term) piece? It has always been my sense that it is best to mix Smart Beta strategies, like value, low volatility, and momentum, in a portfolio and hold them as part of a core piece of a client’s portfolio. That position probably comes from speaking with countless advisors who have managed to completely mistime their exposure to these strategies. Some would argue that there is no need to buy and hold various Smart Beta strategies if one has an effective method of rotating among them. Fair point. In an effort to put some numbers behind these two options, consider the following study.
I decided to take two of the best-known Smart Beta ETFs, The PowerShares FTSE RAFI US 1000 ETF (PRF) and the PowerShares DWA Momentum ETF (PDP) and run a simple test to see if rotating between PRF and PDP worked better than buying and holding the two in equal portions. PDP began trading on March 1, 2007 and PRF began trading on December 20, 2005—so these are ETFs that have been around for quite a while now. I ran two portfolios from September 30, 2007 through February 28, 2015. The first portfolio simply bought 50% PDP and 50% PRF….nothing more. The second portfolio rotated between PDP and PRF (either completely in one or the other). The way that I determined if the portfolio should own PDP or PRF was to see which of the two had the best trailing 6 month performance. This was evaluated monthly. On September 30, 2007, PDP was bought because it had better trailing six month performance than PRF. I moved on to the next month and if PDP still had better trailing 6 month performance than PRF I remained 100% invested in PDP. If, on the other hand, PRF had better trailing 6 month performance, I switched to PRF. This was repeated monthly throughout the test period.
The results are shown below:
Source: Yahoo! Finance. 9/30/07 – 2/28/15. Returns are inclusive of dividends, but do not include transaction costs.
In this study, the clear winner is buying and holding equal portions of PDP and PRF. Not switching back and forth. Just sitting tight and letting these Smart Beta ETFs do their thing. Switching between the two based on trailing 6 month returns resulted in lower returns and higher standard deviation. It also entailed making the 14 switches along the way. Buying 50% of PDP and 50% of PRF resulted in better performance than the S&P 500 (SPY), but switching also lagged the broad market. It is entirely possible that using some other methodology for determining which of the two to own could work better….and may even outperform the simple approach of buying equal portions of each. However, this should at least give someone pause before embarking on a Smart Beta trading strategy.
Part of the reason that mixing Momentum and Value works so well is that they tend to outperform at different times. During the period of this study, the correlation of excess returns between PDP and PRF was -0.17. If you buy and hold the two, you receive the correlation benefits. If you switch between the two, you lose the correlation benefits. The switching mechanism that I used for this study (trailing 6 month returns), is a trend following approach—which means that you miss out on the correlation benefits at the turns.
This all may seem strange coming from a shop like Dorsey Wright, known for Tactical Asset Allocation strategies. After all, aren’t we all about rotating to what is strong? Here is the key point: There is a difference between rotating among a broad number of securities with correlations all over the map and rotating among a small number of Smart Beta strategies which have negatively correlated excess returns. Rotating among the former can be quite profitable over time, while using a trend following approach to rotate among the latter may not.
Sometimes, the answer to how to achieve success in the markets is to simplify rather than to complicate. Smart Beta may just be one of those times where simplification (i.e. buying and holding equal portions of different winning Smart Beta factors) makes the most sense.
Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Some performance information presented 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 this strategy during a specific period. Back-tested performance results have certain limitations. Such results do not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. Back-testing performance also differs from actual performance because it is achieved through retroactive application of a model investment methodology designed with the benefit of hindsight.