A Momentum Based Core Equity Strategy (Part 4)

June 14, 2016

To read Part 1 click here

To read Part 2 click here

To read Part 3 click here

The Core Equity strategy uses the three factor strategies discusses in Part 3.  In order to keep things as simple and non-optimized as possible I just included each model at a 1/3 weight of the total portfolio.  However, by using three different models you can adjust the weightings of each one to suit the end investor’s needs.  For example, if you needed less volatility you can just increase the weight of that model in the combined portfolio.

The Core Equity strategy is rebalanced monthly just like the individual factor models are.  Since a stock can be included in more than one of the factor models, the final model isn’t necessarily 300 stocks with equal weights.  Some stocks will have larger weights than others because they are in multiple models.  That is the only weighting difference though – there is no market capitalization or factor adjustment made to the stock weightings.

CE

In order to judge the fourth factor, size, I modified the final portfolio construction process to account for market cap.  Each stock’s market cap along with how many of the three factor models it was in was taken into account.  A mega cap stock in only one of the factor models might have a higher weight than a smaller cap stock in multiple models in this scenario.  Generally speaking, market capitalization weighting is sub-optimal for investment returns (not for capacity) and that is one big reason why Smart Beta has taken off.  We see the same thing here when we adjust for market cap.

CE2

The returns for the final Core Equity strategy add significant value over the broad market while keeping the volatility (standard deviation) close to that of the benchmark (below for a cap weight version of the Core Equity strategy).  More importantly, it helps smooth out the ride of the individual factor models.  In 1999, for example, Low Volatility was a large underperformer, but momentum was strong enough to carry the overall portfolio to strong returns.  Just two years later in 2001, the roles were reversed and it was Low Volatility and Value picking up the slack for the poor momentum returns.  You can see similar things happening in years like 2006, 2007, and 2011.  I think this point is vastly underrated because investors tend to abandon strategies at exactly the wrong times – after they have underperformed and are due for a rebound.  Combining all three factor strategies into one large Core Equity portfolio helps mask the underperformance of specific factor models and helps investors stay with underperforming strategies.

There are probably an infinite number of ways you can construct a core equity strategy using different factors.  Here, I have looked at just one that was designed to be extremely simple, non-optimized, and robust going forward.  I used some custom models to create the underlying factor models, but they shouldn’t be so dramatically different from existing ETF’s or mutual funds that something similar couldn’t be done on a smaller scale.  I’m sure there are better ways to construct the factor models and put them together in the final Core Equity strategy.  If you have any ideas about how that can be done I would love to hear them!

 

The returns used within this article are the result of a back-test using indexes that are not available for direct investment.  Returns do include dividends, but do not include transaction costs.  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 discussed 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.  Dorsey, Wright & Associates believes the data used in the testing to be from credible, reliable sources, however; Dorsey, Wright & Associates, LLC (collectively with its affiliates and parent company, “DWA”) makes no representation or warranties of any kind as to the accuracy of such data. Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  

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Core/Satellite International Equity Exposure

June 14, 2016

The technical picture of the U.S. Dollar Spot Index (DX/Y) continues to show signs of weakness.  Over the past year, we have seen a series of lower lows, a trendline break in March of this year, and then a reversal to a column of O’s this month, as shown in the chart below.

dxy II

The strength or weakness of the U.S. Dollar has far-reaching effects on a variety of asset classes.  However, for investors in international equities, this U.S. Dollar weakness can actually be a welcomed development as international securities can help protect investors from a falling dollar.  All other things equal, if the currencies of the foreign markets you are invested in (i.e. Euro) strengthen while the dollar continues to fall, these investments will be worth more when converted back into dollars. What a great way to hedge the greenback.

Among the most popular ways that investors tend to get that international equity exposure is through the $60 billion iShares MSCI EAFE ETF (EFA), which provides investors with broad exposure to companies across Europe, Australia, Asia, and the Far East.  However, this ETF–like many other international equity ETFs–is weighted by capitalization.  That may be fine if the large and mega caps are generating strong returns.  However, it can be a challenge if there are better returns in small or mid cap companies.

For a variety of reasons, many advisors like to keep a core position in a capitalization-weighted ETF, like EFA.  However, see the efficient frontier below to get a sense of the potential benefits of adding an actively managed “satellite” strategy to core EFA exposure.

intl efficient frontier

Source: Dorsey Wright and Yahoo! Finance.  Period 3/31/06 – 5/31/16.  Returns include dividends.

The efficient frontier above shows the risk and return profile of different combinations of the iShares MSCI EAFE ETF (EFA) and our Systematic Relative Strength International portfolio.  As shown above, the Systematic Relative Strength International portfolio has had much higher returns over time, albeit with slightly higher standard deviation.  Deciding how to get international equity exposure doesn’t have to be a binary decision between these two strategies.  An investor may choose to make a satellite allocation to Systematic RS International.  Note that from the efficient frontier above, a 50/50 allocation between EFA and Systematic RS International had returns that were several percent higher with standard deviation that was only about 1 percent higher than EFA alone over this period of time.

Some quick facts on our Systematic RS International portfolio:

  • Inception: 3/31/2005
  • Invests in 30-40 ADRs from both emerging and developed international markets
  • Available on a variety of SMA and UMA platforms.  For example, it is available at Stifel, UBS, RBC, Envestnet, Schwab, TD Ameritrade, Fidelity, and more.

Performance is shown below:

intl performance

intl performance II

Period 3/31/05 – 5/31/16.

A core/satellite approach to international equity exposure is a popular way to construct an allocation and we believe that our Systematic RS International portfolio can be an effective way to get that satellite exposure.

For additional information about Systematic RS International, please contact Andy Hyer at 626-535-0630 or andyh@dorseymm.com.

The performance represented in this brochure is based on monthly performance of the Systematic Relative Strength International Model.  Net performance shown is total return net of management fees, commissions, and expenses for all Dorsey, Wright & Associates managed accounts, managed for each complete quarter for each objective, regardless of levels of fixed income and cash in each account.  The advisory fees are described in Part 2A of the adviser’s Form ADV.  The starting values on 3/31/2006 are assigned an arbitrary value of 100 and statement portfolios are revalued on a trade date basis on the last day of each quarter.  All returns since inception of actual Accounts are compared against the NASDAQ Global ex US Index.  The NASDAQ Global ex US Index Total Return Index is a stock market index that is designed to measure the equity market performance of global markets outside of the United States and is maintained by Nasdaq.  A list of all holdings over the past 12 months is available upon request.  The performance information is based on data supplied by the Manager or from statistical services, reports, or other sources which the Manager believes are reliable.  There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities.  Past performance does not guarantee future results. In all securities trading, there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown. Investors should have long-term financial objectives when working with Dorsey, Wright & Associates.

 

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