Almost all of the performance from a relative strength or momentum model comes from the upper end of the ranks. We run different models all the time to test different theories or to see how existing decision rules work on different groups of securities. Sometimes we are surprised by the results, sometimes we aren’t. But the more we run these tests, the more some clear patterns emerge.
One of these patterns we see constantly is all of the outperformance in a strategy coming from the very top of the ranks. People are often surprised at how quickly any performance advantage disappears as you move down the ranking scale. That is one of the things that makes implementing a relative strength strategy so difficult. You have to be absolutely relentless in pushing the portfolio toward the strength because there is often zero outperformance in aggregate from the stuff that isn’t at the top of the ranks. If you are the type of person that would rather “wait for a bounce” or “wait until I’m back to breakeven,” then you might as well just equal-weight the universe and call it a day.
Below is a chart from a sector rotation model I was looking at recently. This model uses the S&P 500 GICS sub-sectors and the ranks were done using a point & figure matrix (ie, running each sub-sector against every other sub-sector) and the portfolio was rebalanced monthly. You can see the top quintile (ranks 80-100) performs quite well. After that, good luck. They are all clustered together well below the top quintile.
This is a constant theme we see. The very best sectors, stocks, markets, and so on drive almost all of the outperformance. If you miss a few of the best ones it is very difficult to outperform. If you are unwilling to constantly cut the losers and buy the winners because of some emotional hangup, it is extremely difficult to outperform. The basket of securities in a momentum strategy that delivers the outperformance is often smaller than you think, so it is crucial to keep the portfolio focused on the top-ranked securities.
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.