Diversification and Asset Class Rotation

February 7, 2017

Diversification is the cornerstone of Modern Portfolio Theory (MPT), introduced by Harry Markowitz in 1952, with the goal of achieving higher risk-adjusted returns overtime.  The problem with diversification is that it works great until the markets are dominated by one asset class for multi-year stretches. This is what we have seen for the past four years as the S&P 500 Index SPX has climbed to new highs and has continued to extend our current bull run. If your portfolios have diversified away from US equities during this time, you have more than likely under performed on a total return basis. This often raises the question from clients of “What have you done for me lately that I cannot do myself with SPY?” What many investors tend to forget is that market cycles change and so too does leadership.

The chart below is a take on the classic Callan chart with 11 asset class returns over a 16 year period. In this chart we compare 10 asset classes to large cap equities (S&P 500), which is held in a static position on the chart.



(performance data in the image above from FactSet from 12/31/99 – 12/31/16)

For the last four years, US equities have been the best place to invest. In the prior 12 years, however, you would have been well-served incorporating other asset classes. In fact, during the 2000-2001 and 2008-2009 downturns you would have been better off owning almost anything other than Large Cap equities. Going forward, is Large Cap equity domination going to continue, or are we going to see markets revert back to pre-2013 distribution of returns?  One of the tools that can help you in evaluating both current leadership and potential opportunities is the Dynamic Asset Level Investing (D.A.L.I) ® tool. On a high level, D.A.L.I uses relative strength to rank six asset classes, and then allows you to delve into sub-asset class opportunities for each. The result is an unbiased, objective view of the markets that is adaptive to change.

Our Systematic Relative Strength Global Macro Portfolio is another solution that is easy to utilize at numerous custodians and trading platforms. The Portfolio provides broad diversification across markets, sectors, styles, Fixed Income, Currencies, Commodities as well as inverse domestic and international equities. The Portfolio is positioned to efficiently take advantage of risk capital globally where leadership trends are compelling. For the past four years we have seen a large allocation to US equity markets, although this has not always been the case.

GM Allocation

If you would like more information on the Dorsey Wright SMA or would like a handout copy of the charts in this presentation please contact Andy Hyer at andyh@dorseymm.com.

The relative strength strategy is not a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Relative strength is a measure of price momentum based on historical activity.  Relative strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon.


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