Systematic Relative Strength

Will momentum “work” in the future just because it did in the past? Or, is momentum susceptible to having its returns arbitraged away? Valid question, and one that comes up regularly.

First, just a quick review of how momentum has performed in the past. There are a number of white papers on this topic, but results of a white paper by RBC Capital Markets are summarized below:

Over this period of time, momentum outperformed in every single decade. It also outperformed the S&P 500 by 3.7% annually over the test period. This is just an academic formulation of momentum and there are other formulations that may be better or worse, but the conclusion is pretty clear: momentum is a very robust return factor.

I think there are two key reasons why momentum returns have not been arbitraged away up to this point and why they are unlikely to be arbitraged away in the future.

First, as long as there is momentum in the underlying fundamentals of companies, there will be price momentum in stocks.

Consider, the strong momentum of revenue of Microsoft (MSFT) in the 1990′s. I only had revenue data going back to mid-1994, but the explosive growth is very clear.

Source: FactSet, June 1994 - December 1999, Trailing 12 month revenue for each quarter

Just as there was momentum in the underlying fundamentals of the company, there was also strong price momentum in the stock during the 1990′s. In fact, MSFT outperformed the S&P 500 nine out of ten years in the 1990′s.

Also, consider the revenue growth of Apple Computer since 2000:

Source: FactSet, December 1999 - June 2014, Trailing 12 month revenue for each quarter

Again, there was tremendous momentum in the underlying fundamentals of the company and there was also strong price momentum in the stock. AAPL has outperformed the S&P 500 every year since 2000, except for three.

In a capitalistic economy, I suspect that there will always be those companies that break out from the pack and are able to experience dramatic growth.

Second, there is a behavioral explanation for momentum that I don’t believe is likely to go away. This is summarized by Andrew Ang in his book Asset Management: A Systematic Approach to Factor Investing.

In the main behavioral theories, momentum arises because of the biased way that investors interpret or act on information. Suppose good news on a stock comes out. Momentum can be generated in two ways. First, investors could have delayed overreaction to this news, causing the price to persistently drift upward. Second, investors could underreact to the news. The price initially goes up, but it does not go up as much as it should have to fully reflect how good the news actually was.

This behavioral explanation is in direct conflict with the Efficient Markets Hypothesis which states that prices immediately reflect any good news. As Ang points out, rather than investors immediately reacting the news, there tends to be a delayed response, a cascading effect, that creates price momentum in the stock as more and more investors act on the good fundamental news from the company.

So yes, I think it is possible for momentum returns to be arbitraged away, but I just don’t think it is likely. That is a tall task for momentum in underlying companies to cease to exist and for investors to overcome behavioral tendencies that have been in place for a very long time.

Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. These examples are presented for illustrative purposes only and do not represent a past recommendation. A momentum strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Dorsey Wright currently owns AAPL.

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 8/18/14:

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 (8/11/14 - 8/15/14) 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.

Among our SMA strategies that have been in highest demand this year has been our Systematic RS International portfolio. Top holdings are shown below:

As of 7/31/14

Here is a quick overview of what these companies do (Source: Yahoo! Finance):

Bitauto Holdings (BITA): Bitauto Holdings Limited provides Internet content and marketing services for the automotive industry primarily in the People’s Republic of China.

Vipshop Holdings (VIPS): Vipshop Holdings Limited, through its subsidiaries, operates as an online discount retailer for various brands in the People’s Republic of China.

Gruma SAB de CV (GMK): Gruma, S.A.B. de C.V., through its subsidiaries, produces, and sells corn flour, wheat flour, tortillas, and other related products.

Empresa Distrib Comercializadora Norte (EDN): Empresa Distribuidora y Comercializadora Norte S.A., a public service company, is engaged in the distribution and sale of electricity in Argentina.

Seiko Epson (SEKEY): Seiko Epson Corporation, together with its subsidiaries, is engaged in the development, manufacture, and sale of information-related equipment, devices and precision products, sensing and industrial solutions, and others, as well as provision of related services.

Vestas Wind Systems (VWDRY): Vestas Wind Systems A/S engages in the manufacture and sale of wind turbines and wind power systems worldwide.

Pampa Energia SA (PAM): Pampa Energía S.A., together with its subsidiaries, generates, transmits, and distributes electricity in Argentina.

Telekom SA Soc LTD (TLKGY): Pampa Energía S.A., together with its subsidiaries, generates, transmits, and distributes electricity in Argentina.

YFP SA (YFP): YPF Sociedad Anónima, an energy company, is engaged in the exploration, development, and production of crude oil, natural gas, and liquefied petroleum gas (LPG) in Argentina.

Sysmex (SSMXY): Sysmex Corporation, together with its subsidiaries, engages in the research and development, production, sale, service, and support of diagnostic instruments, reagents, and software worldwide.

To receive a fact sheet for the strategy, please e-mail [email protected] or call 626-535-0630.

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. A list of all holdings for the past 12 months is available upon request.

Shown below are Point & Figure charts of the 16 ETFs for which Dorsey Wright & Associates is the index provider (as of 8/13/14):

The information found on Dorsey, Wright & Associates’ Web Pages has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this report without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions. Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such information has not been verified by Dorsey, Wright and Associates, LLC (DWA) or the information provider and DWA and the information providers make no representations or warranties or take any responsibility as to the accuracy or completeness of any recommendation or information contained herein.

Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities or commodities mentioned herein. This report or chart does not purport to be a complete description of the securities or commodities, market or developments to which reference is made. There may be instances when fundamental, technical, and quantitative opinions may not be in concert.

Each investor should carefully consider the investment objectives, risks and expenses of any Exchange-Traded Fund (“ETF”) prior to investing. Before investing in an ETF investors should obtain and carefully read the relevant prospectus and documents the issuer has filed with the SEC. To obtain more complete information about the product the documents are publicly available for free via EDGAR on the SEC website (http://www.sec.gov).

PDP: Prior to the fund inception date (3/1/07), chart is created using extrapolated index data.

DWAS: Prior to the fund inception date (7/19/2012), the chart is created from extrapolated index data.

DWAQ: Prior to fund inception date (4/30/03), chart is created using extrapolated index data (DYO), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA NASDAQ Technical Leaders Index (TLNASDAQ)

PIZ: Prior to the fund inception date (12/28/2007), chart is created using extrapolated index data.Prior to the fund inception date (12/28/2007), chart is created using extrapolated index data.

PEZ: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZZK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Consumer Cyclicals Technical Leaders Index (TLCONCYC)

PFI: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZFK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Financial Technical Leaders Index (TLFINANCE)

PRN: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZLK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Industrials Technical Leaders Index (TLINDUST)

PSL: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZSK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Consumer Staples Technical Leaders Index (TLCONSTA)

PTF: Prior to the fund inception date (10/12/2006), chart is created using extrapolated index data. and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Technology Technical Leaders Index (TLTECH)

PTH: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZXK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Healthcare Technical Leaders Index (TLHEALTH)

PUI: Prior to fund inception date (10/25/05), chart is created using extrapolated index data (DWU), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Utilities Technical Leaders Index (TLUTIL)

PXI: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZKK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Energy Technical Leaders Index (TLENERGY)

PYZ: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZBK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Basic Materials Technical Leaders Index (TLBASMAT)

FV: Prior to the fund inception date (3/6/2014), chart is created using extrapolated index data (FTRUST5)

IFV: Prior to the fund inception date (7/23/2014), chart is created using extrapolated index data.

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 8/11/14:

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.

Are you getting paid for the risk that you are taking? There are a number of statistics that are designed to help an investor make that evaluation for any given strategy. Sharpe ratio, which measures unit of return per unit of standard deviation can be helpful in this regard. In the case of our Systematic RS International portfolio (available as a separately managed account), evaluating the Sharpe ratio, in addition to standard deviation and annualized returns can be helpful. Looking at the statistics below one can see that the Systematic RS International (Net) has outperformed the MSCI EAFE Index by 5.58% annually since its inception date of March 31, 2006. However, one would also note that the standard deviation (volatility) of the Systematic RS International portfolio has been 4.42% higher than the MSCI EAFE. Do those excess returns justify the higher volatility?

Source: Dorsey Wright. Click here for disclosures.

Add to those statistics the fact that the Sharpe ratio for the Systematic RS International portfolio has been nearly double that of the MSCI EAFE since March 31, 2006 and I would suggest that the answer is yes to the question of whether or not an investor is getting adequately compensated for the risk taken in this portfolio.

The statistics above are based on total price returns, inclusive of dividends and transaction costs. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss.

Performance since inception is shown below:

E-mail [email protected] or call 626-535-0630 to receive a fact sheet for this portfolio.

Historical Performance Of the Dorsey, Wright Systematic Relative Strength International Strategy 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 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 II 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 MSCI EAFE Total Return Index. The MSCI EAFE Total Return Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the United States and Canada and is maintained by MSCI Barra. 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. Definition of statistical terms: Performance: Net annualized performance. Volatility: Annualized standard deviation. Standard deviation shows how much variation or dispersion exists from the average value. Beta: A measure of systematic or market-related risk. Alpha: A measure of non-market return associated with the portfolio. See Modern Portfolio Theory for more information. Correlation: Compresses covariance into a range of +/- 1. A negative correlation indicates an inverse relationship whereas a positive correlation is indicative of a direct relationship. Annual turnover: An annualized measure of the percentage of the portfolio that was traded. 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.

The table below shows the performance of a universe of mid and large cap U.S. equities, broken down by relative strength decile 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 (8/4/14 - 8/8/14) 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.

“How do you manage risk?” Not surprisingly, this continues to be one of the first questions out of investors mouths as they consider any strategy. Even with the last five years providing one of the strongest bull markets in history, investors vividly remember the pain of the last two bear markets.

How we manage risk depends on the strategy. For some of our portfolios, rotating out of equities and into fixed income, currencies, or even inverse equities is an option. However, for our Systematic RS Growth portfolio, risk management is handled, in part, by employing an exposure overlay that, when activated, causes sales to go to cash and not be reinvested until indicated. This portfolio invests in up to 25 U.S. Mid and Large Cap equities demonstrating, what we believe to be, favorable relative strength characteristics. The strategy will hold up to 50% cash if necessary. Our exposure to cash in this portfolio is shown below:

Source: Dorsey Wright. Estimate based on monthly cash values of a sample Growth portfolio.

Using cash as a way to seek to mitigate market losses has real appeal to investors who want to invest in equities, but also want to know that that there is a plan for risk management. Over time, the results have been very good as shown below. While the portfolio has still had periods where it has lost money, the cash overlay has indeed helped to buffer some of the downside risk.

As of 7/31/14

Click here for a fact sheet or contact Andy at 626-535-0630 or [email protected] with questions. Click here for a list of platforms where our separately managed accounts are available.

Historical Performance Of the Dorsey, Wright Systematic Relative Strength Growth Strategy: The performance represented in this brochure is based on monthly performance of the Systematic Relative Strength Growth Model. Net performance shown is total return net of management fees 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 II of the adviser’s Form ADV. The starting values on 12/31/2006 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 S&P 500 Index. The S&P 500 is a stock market index based on the market capitalizations of 500 leading companies publicly traded in the U.S. stock market, as defined by Standard & Poor’s. 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. 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. The inception for this strategy was 12/31/1994. However, the strategy underwent a material change that was complete on 12/31/2006. The material changes included adding an exposure overlay and a systematic stock selection process.

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 8/5/14.

The 10-day moving average of this indicator is 55% and the one-day reading is 34%. Dips in this index have often provided good opportunities to add 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.

Shown below are Point & Figure charts of the 16 ETFs for which Dorsey Wright & Associates is the index provider (as of 8/5/14):

The information found on Dorsey, Wright & Associates’ Web Pages has been prepared without regard to any particular investor’s investment objectives, financial situation, and needs. Accordingly, investors should not act on any recommendation (express or implied) or information in this report without obtaining specific advice from their financial advisors and should not rely on information herein as the primary basis for their investment decisions. Information contained herein is based on data obtained from recognized statistical services, issuer reports or communications, or other sources, believed to be reliable. However, such information has not been verified by Dorsey, Wright and Associates, LLC (DWA) or the information provider and DWA and the information providers make no representations or warranties or take any responsibility as to the accuracy or completeness of any recommendation or information contained herein.

Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities or commodities mentioned herein. This report or chart does not purport to be a complete description of the securities or commodities, market or developments to which reference is made. There may be instances when fundamental, technical, and quantitative opinions may not be in concert.

Each investor should carefully consider the investment objectives, risks and expenses of any Exchange-Traded Fund (“ETF”) prior to investing. Before investing in an ETF investors should obtain and carefully read the relevant prospectus and documents the issuer has filed with the SEC. To obtain more complete information about the product the documents are publicly available for free via EDGAR on the SEC website (http://www.sec.gov).

PDP: Prior to the fund inception date (3/1/07), chart is created using extrapolated index data.

DWAS: Prior to the fund inception date (7/19/2012), the chart is created from extrapolated index data.

DWAQ: Prior to fund inception date (4/30/03), chart is created using extrapolated index data (DYO), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA NASDAQ Technical Leaders Index (TLNASDAQ)

PIZ: Prior to the fund inception date (12/28/2007), chart is created using extrapolated index data.Prior to the fund inception date (12/28/2007), chart is created using extrapolated index data.

PEZ: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZZK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Consumer Cyclicals Technical Leaders Index (TLCONCYC)

PFI: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZFK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Financial Technical Leaders Index (TLFINANCE)

PRN: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZLK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Industrials Technical Leaders Index (TLINDUST)

PSL: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZSK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Consumer Staples Technical Leaders Index (TLCONSTA)

PTF: Prior to the fund inception date (10/12/2006), chart is created using extrapolated index data. and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Technology Technical Leaders Index (TLTECH)

PTH: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZXK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Healthcare Technical Leaders Index (TLHEALTH)

PUI: Prior to fund inception date (10/25/05), chart is created using extrapolated index data (DWU), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Utilities Technical Leaders Index (TLUTIL)

PXI: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZKK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Energy Technical Leaders Index (TLENERGY)

PYZ: Prior to fund inception date (10/12/06), chart is created using extrapolated index data (EZBK), and the fund tracked this index through 2/18/14. Effective 2/19/14, the fund changed the index that it tracks to DWA Basic Materials Technical Leaders Index (TLBASMAT)

FV: Prior to the fund inception date (3/6/2014), chart is created using extrapolated index data (FTRUST5)

IFV: Prior to the fund inception date (7/23/2014), chart is created using extrapolated index data.