Systematic Relative Strength

Michael Batnick of The Irrelevant Investor cites statistics from SPIVA showing that 79.59% of large-cap managers have failed to beat their benchmark over the last 10 years then makes these astute observations:

I believe the days of superstar stock pickers is a thing of the past. For many of these professionals, career risk is too large a hurdle to overcome. Straying too far from the index keeps their returns looking a lot like it and fees generally eat up any alpha they might earn. Aside from career risk, here are a few other risk factors to consider that can negatively affect a portfolio manager.

1. Maybe they get divorced
2. Maybe they lose a key analyst
3. Maybe they go through a bad stretch and start second guessing themselves
4. Maybe they leave for another company.
5. Maybe they want to spend more time with their kids.

This is just too many maybes and why I believe that if you’re going to deviate from the index, it’s important to do so in a systematic way. With quantitative strategies, you understand there will be times when it falls out of favor, in fact you sign up for that ahead of time. However, if a stock picker hits a rough patch, you don’t know they will ever regain the ability it appeared they once had. Furthermore, it can be difficult to ascertain what caused them to outperform in the first place; that whole thing about distinguishing luck from skill.

When considering active strategies, it’s important for us that we’re not relying on anyone’s intuition, expertise, or mental or emotional well being. We don’t want our PMs speaking with management, doing channel checks or backing out the cash. We want them to follow their models with as little interference as humanly possible.

A focus on process over short-term results is a hallmark of DWA. We long ago recognized the need to systematize strategy decision rules in order to minimize the negative effect of human emotion on investment results. Part of the reason that we were comfortable with this is because of the mountain of research on momentum which suggests that momentum is a premier investment factor. With something that effective over time, why mess with it? Honing our craft is an ongoing process, but we take great pride in the level of consistency of our investment process over time.

Too often, our industry notes the percentage of active managers that fail to beat an index and comes to the wrong conclusion—essentially throwing the baby out with the bathwater. A much more telling statistic would be the percentage of systematic vs. non-systematic investment managers that beat an index over time. I suspect that the former number would be much higher than the latter.

The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.

HT: Jim O’Shaughnessey

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 (9/14/15 – 9/18/15) is as follows:

This example is presented for illustrative purposes only and does not represent a past recommendation. The performance above is based on pure price returns, not inclusive of dividends or all transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

So far this year, all 9 of our PowerShares DWA Momentum Sectors are outperforming their cap-weighted peers. In some cases (Healthcare, Technology, and Consumer Staples) the outperformance of momentum is quite large.

Source: Dorsey Wright, Updated through 9/17/15, Performance is price only, not inclusive of dividends or all transaction costs

The PowerShares DWA Momentum Sector ETFs are constructed as follows:

• Invest in 30-75 Small, Mid, and Large Cap Stocks
• Stocks are selected for the index based on demonstrating favorable, in our view, momentum characteristics
• Rebalanced on a quarterly basis

Dorsey Wright is the index provider for this suite of momentum ETFs at PowerShares. See www.powershares.com for more information. The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value.

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 9/15/15.

This index has rebounded after hitting a single-day low of 8% on 8/25/15. The 10-day moving average of this indicator is 30% and the one-day reading is 48%. Dips in this index have often provided good opportunities to add money to relative strength strategies.

This example is presented for illustrative purposes only and does not represent a past recommendation. The performance above is based on pure price returns, not inclusive of dividends or all transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

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 9/9/15.

The 10-day moving average of this indicator is 26% and the one-day reading is 29%. Dips in this indicator have often provided good opportunities to add money to relative strength strategies.

This example is presented for illustrative purposes only and does not represent a past recommendation. The performance above is based on pure price returns, not inclusive of dividends or all transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

Bridgeway recently provided a nice review of the historical small-cap effect:

The Center for Research in Security Prices (CRSP) divides all stocks traded on the New York Stock Exchange into 10 deciles based on company market capitalization. Decile 1 includes the largest of all companies, while decile 10 represents the smallest of small-cap stocks, known as ultra-small companies.

Some observations:

• From 1926-June of 2015, small-cap stocks (CRSP 6-8) outperformed ultra-large stocks (CRSP 1) by 2.98% annually
• Small-cap stocks (CRSP 6-8) outperformed ultra-large stocks (CRSP 1) in 6 out of the 10 periods shown in the above table
• Markets go through extended periods of time favoring large-cap stocks vs. small-cap stock and vice versa

This data suggests that there can be meaningful benefits from including small-cap exposure as as part of an asset allocation. Of course, our personal preference for how to get that small-cap exposure is through a disciplined relative strength index.

A look at the chart of our own PowerShares DWA Small Cap Momentum ETF is shown below:

As of 9/8/15. This PnF chart is constructed using closing prices only. The performance above is based on pure price returns, not inclusive of dividends or all transaction costs.

A brief review of the index construction methodology for the PowerShares DWA Small Cap Technical Leaders Index:

The PowerShares DWA Small Cap Momentum Portfolio (Fund) is based on the Dorsey Wright^® SmallCap Technical Leaders Index (DWA SmallCap Technical Leaders Index). The Fund will normally invest at least 90% of its total assets in equity securities of small capitalization companies that comprise the Index. The Index includes securities pursuant to a Dorsey, Wright & Associates, LLC proprietary selection methodology that is designed to identify companies that demonstrate powerful relative strength characteristics based on that company’s market performance. Approximately 200 companies are selected for inclusion in the Index from the NASDAQ US Benchmark Index. The Fund and the Index are rebalanced and reconstituted quarterly.

The stock market correction over the past month or so caused this chart to pull back to its bullish support line, but it has since reversed back into a column of X’s. In light of the fact that many of the short-term indicators that we follow at Dorsey Wright (NYSEHILO and TWNYSE) have reached oversold levels–even multi-year low levels, investors may wish to consider taking this opportunity put some money to work in this ETF.

Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. Dorsey Wright is the index provider for DWAS and a suite of other Momentum ETFs with PowerShares.

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 9/8/15:

This example is presented for illustrative purposes only and does not represent a past recommendation. The performance above is based on pure price returns, not inclusive of dividends or all transaction costs. Investors cannot invest directly in an index. Indexes have no fees. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

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 (8/31/15 – 9/4/15) is as follows:

This example is presented for illustrative purposes only and does not represent a past recommendation. The performance above is based on pure price returns, not inclusive of dividends or all transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

Anthony Isola of The Christian Science Monitor identified two of the major impediments to creating wealth:

Too many choices and inexperience with complex issues are two of the biggest impediments to creating wealth. Limiting choices and automation, on the other hand, are great ways to improve your decision-making.

For the advisor who is providing relative strength-based solutions for their clients, these two impediments to creating wealth become perfectly surmountable. If I, as a financial advisor employing relative strength-based solutions to my clients, were articulating my value proposition to a prospect here are 3 key points I would make:

• Relative strength provides a way to thoroughly and effectively analyze a broad universe of securities. Take the PowerShares DWA Momentum ETF (PDP) as an example. Every quarter, we take 1,000 securities and evaluate each of them based on their PnF relative strength attributes. The top 100 of our ranks make it into the index. This process is no more difficult with 1,000 securities in the investment universe than it would be if there were 500. Relative strength provides an elegant solution to the challenge of “too many choices.”
• Relative strength provides a sell discipline that is as clearly defined as is the buy discipline. Most investors don’t have a problem coming up with ideas of securities to buy, but when it comes to knowing when to sell that is a different story. The end result is that losing positions can act as a drag on a portfolio for extended periods of time. What you don’t own is every bit as important as what you do own. Many of the guided ETF models on the Dorsey Wright research database are managed using a relative strength matrix. The sell discipline for many of these models is if the security falls out of the top half of the ranks. Just one of the ways that relative strength simplifies decisions that to many would seem complex.
• Finally, I would make sure that a prospect understood that if they entrusted their financial wealth with you, that you would systematize the management of their wealth. Advisors have wholesalers in their office every day presenting a good idea. Most of these wholesalers make a compelling argument for the particular investment that they represent. If an advisor were to change their investment process every time they hear a good idea, their client’s portfolios would end up being a mish-mash of who knows what. Clients want to know that you are carefully monitoring their assets and relative strength provides a logical framework for this task.

Framing discussions with prospects around ways that your relative strength-based investment process can lead to them creating and preserving their wealth could very well be the key to winning new business and then keeping that business for decades to come.

The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Dorsey Wright is the index provider for PDP and a suite of other momentum-based ETFs.