Quote of the Week

April 11, 2014

Mark Abraham, of Abraham Trading:

While a fundamental analyst may be able to properly evaluate the economics underlying a stock, I do not believe they can predict how the masses will process this same information. Ultimately, it is the dollar-weighted collective opinion of all market participants that determines whether a stock goes up or down. This consensus is revealed by analyzing price.

HT: Michael Covel

Posted by:


The Wisdom of Crowds

April 9, 2014

NPR, reporting on “The Good Judgement Project” writes a fascinating story about the wisdom of crowds.  Maybe there is something to this momentum factor after all!  

For the past three years, Rich and 3,000 other average people have been quietly making probability estimates about everything from Venezuelan gas subsidies to North Korean politics as part of the Good Judgment Project, an experiment put together by three well-known psychologists and some people inside the intelligence community.

According to one report, the predictions made by the Good Judgment Project are often better even than intelligence analysts with access to classified information, and many of the people involved in the project have been astonished by its success at making accurate predictions…

…How can that be?

“Everyone has been surprised by these outcomes,” said Philip Tetlock, one of the three psychologists who came up with the idea for the Good Judgment Project. The other two are Barbara Mellers and Don Moore.

For most of his professional career, Tetlock studied the problems associated with expert decision making. His book Expert Political Judgment is considered a classic, and almost everyone in the business of thinking about judgment speaks of it with unqualified awe.

All of his studies brought Tetlock to at least two important conclusions.

First, if you want people to get better at making predictions, you need to keep score of how accurate their predictions turn out to be, so they have concrete feedback.

But also, if you take a large crowd of different people with access to different information and pool their predictions, you will be in much better shape than if you rely on a single very smart person, or even a small group of very smart people.

“The wisdom of crowds is a very important part of this project, and it’s an important driver of accuracy,” Tetlock said.

The wisdom of crowds is a concept first discovered by the British statistician Francis Galton in 1906.

Galton was at a fair where about 800 people had tried to guess the weight of a dead ox in a competition. After the prize was awarded, Galton collected all the guesses so he could figure out how far off the mark the average guess was.

It turned out that most of the guesses were really bad — way too high or way too low. But when Galton averaged them together, he was shocked:

The dead ox weighed 1,198 pounds. The crowd’s average: 1,197.

My emphasis added.  As pointed out by Philip Tetlock, “everyone has been surprised by these outcomes.”  Just like everyone (or many) are surprised by the results of momentum investing.  Yet, momentum works for for the very same reasons that “The Good Judgement Project” is apparently succeeding—the wisdom of the crowds.  It requires a certain amount of humility to turn investment decision-making over to the wisdom of the crowds and humility is not an attribute in great supply on Wall Street.  The vast majority of investment managers in this industry spend large portions of their time convincing others (and themselves) that they are right and “the market” is wrong, but that the market will eventually come around to their way of thinking.  Momentum takes a different approach.  If a given security, or group of securities, are relatively stronger than their peers momentum investors follow those trends—often times without a clear understanding of the fundamental reasons for the superior momentum characteristics.  If the market changes, momentum investors change and reorient their portfolios to adapt to the new leadership.  Momentum investors focus on the process of keeping their portfolios in-tune with market trends rather than praying that the market will eventually prove that any one “expert” opinion will prove correct.

Posted by:


Michael Covel Interviews Tom Dorsey

March 31, 2014

Click here to listen to the story of how Tom came to embrace Point & Figure Charting.

Tommy Pic 06small Michael Covel Interviews Tom Dorsey

Posted by:


Quote of the Week

March 27, 2014

From Meb Faber:

 Most of the alpha out there (or smart beta or whatever it is being called these days) is either hard to find or hard to DO.  And by do, I mean it goes against everything your behavioral instincts tell you to do.  Buying a stock at all time highs is hard to do, and one reason momentum and trend work.  Buying a value investment is hard for many reasons.

Posted by:


The Valuation Game

March 15, 2014

Morningstar analyst, Samuel Lee, describes one of the major challenges facing those investors who look to base their decisions on valuations.  Lee says, that “the problem is that earnings quality–operating, and as-reported, has declined over time.”  He cites Warren Buffet on the topic from one of his shareholder letters:

It was once relatively easy to tell the good guys in accounting from the bad: The late 1960s, for example, brought on an orgy of what one charlatan dubbed ‘bold, imaginative accounting’ (the practice of which, incidentally, made him loved for a time by Wall Street because he never missed expectations). But most investors of that period knew who was playing games. And, to their credit, virtually all of America’s most-admired companies then shunned deception.”In recent years, probity has eroded. Many major corporations still play things straight, but a significant and growing number of otherwise high-grade managers–CEOs you would be happy to have as spouses for your children or as trustees under your will–have come to the view that it’s okay to manipulate earnings to satisfy what they believe are Wall Street’s desires. Indeed, many CEOs think this kind of manipulation is not only okay, but actually their duty.

Lee’s article brings up the question of whether P/E ratios should be compared to their 130-year average or whether it would be better to compare today’s P/E ratios to their 30 or 50-year averages in order to determine whether the broad U.S. equity market is overvalued or undervalued.

Such difficulties with valuation only strengthen the case for trend following.  It’s not that earnings don’t matter–they certainly do.  It’s just not clear in what time frame and to what degree they will impact the stock price.  Investors are free to use any criteria they choose (or none at all) to determine whether they will buy or sell a given stock, ETF, or mutual fund.  Trend followers, like us, spend much less time worrying about concepts like overvalued or undervalued and much more time focusing on executing a strategy that seeks to build a portfolio of securities that have favorable relative strength characteristics.  Over time, we generally end up with a portfolio of securities that many analysts would view as fundamentally strong (at least in retrospect), it’s just that we rely on “the wisdom of the crowds” instead of Wall Street earnings reports.

HT: Abnormal Returns

Posted by:


Survivorship Bias

February 28, 2014

Everyone in the financial services industry has seen awesome-looking backtests for various return factors or trading methods, but most people don’t even know what survivorship bias is.  When I see one of those amazing backtests and I ask how they removed the survivorship bias, the usual answer is “Huh?”

A recent post by Cesar Alvarez at Alvarez Quant Trading shows just how enormous survivorship bias can be for a trend following system.  Most people with amazing backtests, when pushed, will concede there might be “some” effect from survivorship.  None of them ever think it will be this large!

Here, Mr. Alvarez describes the bias and shows the results:

Pre-inclusion bias is using today’s index constituents as your trading universe and assuming these stocks were always in the index during your testing period. For example if one were testing back to 2004, GOOG did not enter the S&P500 index until early 2006 at a price of $390. But your testing could potentially trade GOOG during the huge rise from $100 to $300.

Rules

  • It is the first trading day of the month
  • Stock is member of the S&P500 (on trading date vs as of today)
  • S&P500 closes above its 200 day moving average (with and without this rule)
  • Rank stocks by their six month returns
  • Buy the 10 best performing stocks at the close
survivorshipbias zps7f6ea477 Survivorship Bias

Source: Alvarez Quant Trading

(click on image to enlarge to full size)

Mind-boggling, isn’t it?  The fantastic system that showed 30%+ returns now shows returns of less than 8%!!  (The test period, by the way, was 2004-2013.)

Unfortunately, this is the way much backtesting is done.  It’s much more trouble to acquire a database that has all of the delisted securities and all of the historical index constituents.  That’s expensive and time-consuming, but it’s the only way to get accurate results.  (Needless to say, that’s how our testing is done.  You can link to one of our white papers that additionally includes Monte Carlo testing to make the results even more robust.)  By the way, the pre-inclusion bias also shows very clearly how the index providers actually manage these indexes!

Mr. Alvarez concludes:

People often write about systems they have developed using the current Nasdaq 100 or S&P 500 stocks and have tested back for 5 to 10 years. Looking at this table shows that one should completely ignore those results.

When looking at backtested results, it often pays to be skeptical and to ask some questions about survivorship bias.

Posted by:


It’s All At The Upper End

February 3, 2014

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 earlier this week.  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.  The “Univ” line is a monthly equal-weighted portfolio of all the GICS sub-sectors.  The next quintile (ranks 60-80) barely beats the universe return and probably adds no value after you are done with trading costs, taxes, etc…  Keep in mind that these sectors are still well within the top half of the ranks and they still add minimal value.  The other three quintiles are underperformers.  They are all clustered together well below the universe return.

GICSMatrix zpse4a88b8f Its All At The Upper End

 (Click on image to enlarge)

The overall performance numbers aren’t as good, but you get the exact same pattern of results if you use a 12-Month Trailing Return to rank the sub-sectors instead of a point & figure matrix:

GICS12Mth zpsb3fb152f Its All At The Upper End

 (click on image to enlarge)

Same deal if you use a 6-Month Trailing Return:

GICS6Mth zps8af7edf9 Its All At The Upper End

(click on image to enlarge)

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.

Posted by:


The 1%

January 6, 2014

“The 1%” phrase has been used a lot to decry income inequality, but I’m using it here in an entirely different context.  I’m thinking about the 1% in relation to a recent article by Motley Fool’s Morgan Housel.  Here’s an excerpt from his article:

Building wealth over a lifetime doesn’t require a lifetime of superior skill. It requires pretty mediocre skills — basic arithmetic and a grasp of investing fundamentals — practiced consistently throughout your entire lifetime, especially during times of mania and panic.  Most of what matters as a long-term investor is how you behave during the 1% of the time everyone else is losing their cool.

That puts a little different spin on it.  Maybe your behavior during 1% of the time is how you get to be part of the 1%.  (The bold in Mr. Housel’s quotation above is mine.)

In his article, Housel demonstrates how consistency—in this case, dollar-cost averaging—beats a couple of risk avoiders who try to miss recessions.  We’ve harped on having some kind of systematic investment process here, so consistency is certainly a big part of success.

But also consider what might happen if you can capitalize on those periods of panic and add to your holdings.  Imagine that kind of program practiced consistently over a lifetime!  Warren Buffett’s article in the New York Times, “Buy American.  I Am.” from October 2008 comes to mind.  Here is a brief excerpt of Mr. Buffett’s thinking during the financial crisis:

THE financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher. In the near term, unemployment will rise, business activity will falter and headlines will continue to be scary.

So … I’ve been buying American stocks.

If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.

A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.

Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.

Gee, I wonder how that worked out for him?  It’s no mystery why Warren Buffett has $60 billion—he is as skilled a psychological arbitrageur as there is and he has been at it for a very long time.

As Mr. Housel points out, even with mediocre investing skills, just consistency can go a long way toward building wealth—and the ability to be greedy when others are fearful has the potential to compound success.

Posted by:


DWA Technical Leaders Index Trade Profiles

January 6, 2014

The Dorsey, Wright Technical Leaders Index is composed of a basket of 100 mid and large cap securities that have strong relative strength (momentum) characteristics.  Each quarter we reconstitute the index by selling stocks that have underperformed and by adding new securities that score better in our ranking system.  We began calculating the index in real-time at the end of 2006.  Over the last seven years there have been quite a few deletions and additions as the index has adapted to some very dynamic market conditions.

Any relative strength or momentum-based investment strategy is a trend following strategy.  Trend following has worked for many years in financial markets (although not every year).  These systems are characterized by a several common attributes: 1) Losing trades are cut quickly and winners are allowed to run, 2) there are generally a lot of small losing trades, and 3) all of the money is made by the large outliers on the upside.  When we look at the underlying trades inside of the index over the years we find exactly that pattern of results.  There is a lot going on behind the scenes at each rebalance that is designed to eliminate losing positions quickly and maintain large allocations to the true winners that drive the returns.

We pulled constituent level data for the DWATL Index going back to the 12/31/2006 rebalance.  For each security we calculated the return relative to the S&P 500 and how many consecutive quarters it was held in the index.  (Note: stocks can be added, removed, and re-added to the index so any individual stock might have several entries in our data.)  The table below shows summary statistics for all the trades inside of the index over the last seven years:

TLTable zps9d3df2ae DWA Technical Leaders Index Trade Profiles

 

The data shows our underlying strategy is doing exactly what a trend following system is designed to accomplish.  Stocks that aren’t held very long (1 to 2 quarters), on average, are underperforming trades.  But when we are able to find a security that can be held for several quarters, those trades are outperformers on average.  The whole goal of a relative strength process is to ruthlessly cut out losing positions and to replace them with positions that have better ranks.  Any investor makes tons of mistakes, but the system we use to reconstitute the DWATL Index is very good at identifying our mistakes and taking care of them.  At the same time, the process is also good at identifying winning positions and allowing them to remain in the index.

Here is the same data from the table shown graphically:

TLChart zps7c20d6fe DWA Technical Leaders Index Trade Profiles

 

You can easily see the upward tilt to the data showing how relative performance on a trade-level basis improves with the time held in the index.  For the last seven years, each additional consecutive quarter we have been able to keep a security in the Index has led to an average relative performance improvement of about 920 basis points.  That should give you a pretty good idea about what drives the returns: the big multi-year winners.

We often speak to the overall performance of the Index, but we sometimes forget what is going on behind the scenes to generate that return.  The process that is used to constitute the index has all of the characteristics of a trend following system.  Underperforming positions are quickly removed and the big winning trades are allowed to remain in the index as long as they continue to outperform.  It’s a lot like fishing: you just keep throwing the small ones back until you catch a large one.  Sometimes it takes a couple of tries to get a keeper, but if you got a big fish on the first try all the time it would be called “catching” not “fishing.”  I believe part of what has made this index so successful over the years is there is zero human bias that enters the reconstitution process.  When a security needs to go, it goes.  If it starts to perform well again, it comes back.  It has no good or bad memories.  There are just numbers.

The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses.  Past performance is no guarantee of future returns.  Potential for profit is accompanied by potential for loss.  A list of all holdings for the trailing 12 months is available upon request.

Posted by:


Investor Behavior

January 6, 2014

Marshall Jaffe, in a recent article for ThinkAdvisor, made an outstanding observation:

In a world where almost nothing can be predicted with any accuracy, investor behavior is one of the rare exceptions. You can take it to the bank that investors will continue to be driven by impatience, social conformity, conventional wisdom, fear, greed and a confusion of volatility with risk. By standing apart and being driven solely by the facts, the value investor can take advantage of the opportunities caused by those behaviors—and be in the optimal position to create and preserve wealth.

His article was focused on value investing, but I think it is equally applicable to relative strength investing.  In fact, maybe even more so, as value investors often differ about what they consider a good value, while relative strength is just a mathematical calculation with little room for interpretation.

Mr. Jaffe’s main point—that investors are driven by all sorts of irrational and incorrect cognitive forces—is quite valid.  Dozens of studies point it out and there is a shocking lack of studies (i.e., none!) that show the average investor to be a patient, independent thinker devoid of fear and greed.

What’s the best way to take advantage of this observation about investor behavior?  I think salvation may lie in using a systematic investment process.  If you start with an investment methodology likely to outperform over time, like relative strength or value, and construct a rules-based systematic process to follow for entry and exit, you’ve got a decent chance to avoid some of the cognitive errors that will assail everyone else.

Of course, you will construct your rules during a period of calm and contemplation—but that’s never when rules are difficult to apply!  The real test is sticking to your rules during the periods of fear and greed that occur routinely in financial markets.  Devising the rules may be relatively simple, but following them in trying circumstances never is!  As with most things, the harder it is to do, the bigger the potential payoff usually is.

Posted by:


The Simplicity of Relative Strength

December 16, 2013

One of the ongoing difficulties for investors is finding some kind of simple method for investing.  Relative strength is just such a simple method.  Even simple methods, however, have to be applied!

Tadas Viskanta from Abnormal Returns writes:

…having a plan, even a sub-optimal one, that you can stick to is preferable to having no plan at all. The ongoing challenge for advisors and investors alike is to find a plan that they will not abandon at the first sign of trouble.

That’s an important point.  If you can’t follow a method because it is too complex and if you bail in panic during the first downturn, you’re not going to succeed with any method.

Abnormal Returns revisited this theme recently, in connection with a discussion about systems versus optimization.  Mr. Viskanta pulled a quote from Scott Adams:

Optimizing is often the strategy of people who have specific goals and feel the need to do everything in their power to achieve them. Simplifying is generally the strategy of people who view the world in terms of systems. The best systems are simple, and for good reason. Complicated systems have more opportunities for failure. Human nature is such that we’re good at following simple systems and not so good at following complicated systems.

This has a great deal of applicability to the investing process.  Simple systems are generally more robust than complex systems, and relative strength is about as simple as you can get.  Relative strength is not an optimized system—like most simple systems, it will make plenty of mistakes but its simplicity makes it robust.  (I would note that Modern Portfolio Theory relies on mean variance optimization to construct the “ideal” portfolio.  Optimized systems are both complicated and fragile.)

In practice, complicated systems tend to blow up.  Robust systems are generally more resilient to failure, but will certainly struggle from time to time.

Human nature, I think, makes it difficult to follow any system, whether simple or complex, so discipline is also required.  Investors will improve their chances for success with a simple, robust methodology and the discipline to stick with it.

Posted by:


A Reminder About Real Return

November 20, 2013

The main thing that should matter to a long-term investor is real return.  Real return is return after inflation is factored in.  When your real return is positive, you are actually increasing your purchasing power— and purchasing goods and services is the point of having a medium of exchange (money) in the first place.

A recent article in The New York Times serves as a useful reminder about real return.

The Dow Jones industrial average broke through 16,000 on Monday for the first time on record — well, at least in nominal terms. If you adjust for inflation, technically the highest level was on Jan. 14, 2000.

Adjusting for price changes, the Dow’s high today was still about 1.3 percent below its close on Jan. 14, 2000 (and about 1.6 percent below its intraday high from that date).

There’s a handy graphic as well, of the Dow Jones Industrial Average adjusted for inflation.

DJIAinflationadjusted zps196c90a6 A Reminder About Real Return

Source: New York Times/Bloomberg

(click on image to enlarge)

This chart, I think, is a good reminder that buy-and-hold (known in our office as “sit-and-take-it”) is not always a good idea.  In most market environments there are asset classes that are providing real return, but that asset class is not always the broad stock market.  There is value in tactical asset allocation, market segmentation, strategy diversification, and other ways to expose yourself to assets that are appreciating fast enough to augment your purchasing power.

I’ve read a number of pieces recently that contend that “risk-adjusted” returns are the most important investment outcome.  Really?  This would be awesome if I could buy a risk-adjusted basket of groceries at my local supermarket, but strangely, they seem to prefer the actual dollars.  Your client could have wonderful risk-adjusted returns rolling Treasury bills, but would then also get to have a lovely risk-adjusted retirement in a mud hut.  If those dollars are growing more slowly than inflation, you’re just moving in reverse.

Real returns are where it’s at.

Posted by:


Dumb Talk About Smart Beta?

October 7, 2013

John Rekenthaler at Morningstar, who usually has some pretty smart stuff to say, took on the topic of smart beta in a recent article.  Specifically, he examined a variety of smart beta factors with an eye to determining which ones were real and might persist.  He also thought some factors might be fool’s gold.

Here’s what he had to say about value:

The value premium has long been known and continues to persist.

And here’s what he had to say about relative strength (momentum):

I have trouble seeing how momentum can succeed now that its existence is well documented.

The italics are mine.  I didn’t take logic in college, but it seems disingenuous to argue that one factor will continue to work after it is well-known, while becoming well-known will cause the other factor to fail!  (If you are biased in favor of value, just say so, but don’t use the same argument to reach two opposite conclusions.)

There are a variety of explanations about why momentum works, but just because academics can’t agree on which one is correct doesn’t mean it won’t continue to work.  It is certainly possible that any anomaly could be arbitraged away, but Robert Levy’s relative strength work has been known since the 1960s and our 2005 paper in Technical Analysis of Stocks & Commodities showed it continued to work just fine just the way he published it.  Academics under the spell of efficient markets trashed his work at the time too, but 40 years of subsequent returns shows the professors got it wrong.

However, I do have a background in psychology and I can hazard a guess as to why both the value and momentum factors will continue to persistthey are both uncomfortable to implement.  It is very uncomfortable to buy deep value.  There is a terrific fear that you are buying a value trap and that the impairment that created the value will continue or get worse.  It also goes against human nature to buy momentum stocks after they have already outperformed significantly.  There is a great fear that the stock will top and collapse right after you add it to your portfolio.  Investors and clients are quite resistant to buying stocks after they have already doubled, for example, because there is a possibility of looking really dumb.

Here’s the reason I think both factors are psychological in origin: it is absurdly easy to screen for either value or momentum.  Any idiot can implement either strategy with any free screener on the web.  Pick your value metric or your momentum lookback period and away you go.  In fact, this is pretty much exactly what James O’Shaughnessy did in What Works on Wall Street.  Both factors worked well—and continue to work despite plenty of publicity.  So the barrier is not that there is some secret formula, it’s just that investors are unwilling to implement either strategy in a systematic way–because of the psychological discomfort.

If I were to make an argument—the behavioral finance version—about which smart beta factor could potentially be arbitraged away over time, I would have to guess low volatility.  If you ask clients whether they would prefer to buy stocks that a) had already dropped 50%, b) had already gone up 50%, or c) had low volatility, I think most of them would go with “c!”  (Although I think it’s also possible that aversion to leverage will keep this factor going.)

Value and momentum also happen to work very well together.  Value is a mean reversion factor, while momentum is a trend continuation factor.  As AQR has shown, the excess returns of these two factors (unsurprisingly, once you understand how they are philosophical opposites) are uncorrelated.  Combining them may have the potential to smooth out an equity return stream a little bit.  Regardless, two good return factors are better than one!

Posted by:


Stocks for the Long Run

September 20, 2013

Unlike certain authors, I am not promoting some agenda about where stocks will be at some future date!  Instead, I am just including a couple of excerpts from a paper by luminaries David Blanchett, Michael Finke, and Wade Pfau that suggests that stocks are the right investment for the long run—based on historical research.  Their findings are actually fairly broad and call market efficiency into question.

We find strong historical evidence to support the notion that a higher allocation to equities is optimal for investors with longer time horizons, and that the time diversification effect is relatively consistent across countries and that it persists for different levels of risk aversion.

When they examine optimal equity weightings in a portfolio by time horizon, the findings are rather striking.  Here’s a reproduction of one of their figures from the paper:

optimalequity zpsa19b1cfd Stocks for the Long Run

Source: SSRN/Blanchett, Finke, Pfau  (click to enlarge)

They describe the findings very simply:

Figure 1 also demonstrates how to interpret the results we include later in Tables 2 and 3. In Figure 1 we note an intercept (α) of 45.02% (which we will assume is 45% for simplicity purposes) and a slope (β) of .0299 (which for simplicity purposes we will assume is .03). Therefore the optimal historical allocation to equities for an investor with a 5 year holding period would be 60% stocks, which would be determined by: 45% + 5(3%) = 60%.

In other words, if your holding period is 15-20 years or longer, the optimal portfolio is 100% stocks!

Reality, of course, can be different from statistical probability, but their point is that it makes sense to own a greater percentage of stocks the longer your time horizon is.  The equity risk premium—the little extra boost in returns you tend to get from owning stocks—is both persistent and decently high, enough to make owning stocks a good long-term bet.

Posted by:


From the Archives: Inherently Unstable Correlations

September 19, 2013

No, this is not a post on personality disorders.

Rather, it is a post on the inherently unstable nature of correlations between securities and between asset classes.  This is important because the success of many of the approaches to portfolio management make the erroneous assumption that correlations are fairly stable over time.  I was reminded just how false this belief is while reading The Leuthold Group‘s April Green Book in which they highlighted the rolling 10-year correlations in monthly percentage changes between the S&P 500 and the 10-year bond yield.  Does this look stable to you?  Chart is shown by permission from The Leuthold Group.

Correlation From the Archives: Inherently Unstable Correlations

(Click to Enlarge)

If you are trying to use this data, would you conclude that higher bond yields are good for the stock market or bad?  The answer is that the correlations are all over the map.  In 2006, William J. Coaker II published The Volatility of Correlations in the FPA Journal.  That paper details the changes in correlations between 15 different asset classes and the S&P 500 over a 34-year time horizon.  To give you a flavor for his conclusions, he pointed out that Real Estate’s rolling 5-year correlations to the S&P 500 ranged from 0.17 to 0.75, and for Natural Resources the range was -0.34 to 0.49.   History is conclusive – correlations are unstable.

This becomes a big problem for strategic asset allocation models that use historical data to calculate an average correlation between securities or asset classes over time.  Those models use that stationary correlation as one of the key inputs into determining how the model should currently be allocated.  That may well be of no help to you over the next five to ten years.  Unstable correlations are also a major problem for “financial engineers” who use their impressive physics and computer programming abilities to identify historical relationships between securities.   They may find patterns in the historical data that lead them to seek to exploit those same patterns in the future (i.e. LTCM in the 1990′s.) The problem is that the future is under no obligation to behave like the past.

Many of the quants are smart enough to recognize that unstable correlations are a major problem.  The solution, which I have heard from several well-known quants, is to constantly be willing to reexamine your assumptions and to change the model on an ongoing basis.  That logic may sound intelligent, but the reality is that many, if not most, of these quants will end up chasing their tail. Ultimately, they end up in the forecasting game.  These quants are rightly worried about when their current model is going to blow up.

Relative strength relies on a different premise.  The only historical pattern that must hold true for relative strength to be effective in the future is for long-term trends to exist. That is it.  Real estate (insert any other asset class) and commodities (insert any other asset class) can be positively or negatively correlated in the future and relative strength models can do just fine either way.  Relative strength models make zero assumptions about what the future should look like.  Again, the only assumption that we make is that there will be longer-term trends in the future to capitalize on.  Relative strength keeps the portfolio fresh with those securities that have been strong relative performers.  It makes no assumptions about the length of time that a given security will remain in the portfolio.  Sure, there will be choppy periods here and there where relative strength models do poorly, but there is no need (and it is counterproductive) to constantly tweak the model.

Ultimately, the difference between an adaptive relative strength model and most quant models is as different as a mule is from a horse.  Both have four legs, but they are very different animals.  One has a high probability of being an excellent performer in the future, while the other’s performance is a big unknown.

—-this article originally appeared 4/16/2010.  It’s important to understand the difference between a model that relies on historical correlations and a model that just adapts to current trends.

Posted by:


Bucket Portfolio Stress Test

September 4, 2013

I’ve long been a fan of portfolio buckets or sleeves, for two reasons.  The first reason is that it facilitates good diversification, which I define as diversification by volatility, by asset class, and by strategy.  (We happen to like relative strength as one of these primary strategies, but there are several offsetting strategies that might make sense.)  A bucket portfolio makes this kind of diversification easy to implement.

The second benefit is largely psychological—but not to be underestimated.  Investors with bucket portfolios had better performance in real life during the financial crisis because they didn’t panic.  While the lack of panic is a psychological benefit, the performance benefit was very real.

Another champion of bucketed portfolios is Christine Benz at Morningstar.  She recently wrote a series of article in which she stress-tested bucketed portfolios, first through the 2007-2012 period (one big bear market) and then through the 2000-2012 period (two bear markets).  She describes her methodology for rebalancing and the results.

If you have any interest in portfolio construction for actual living, breathing human beings who are prone to all kinds of cognitive biases and emotional volatility, these articles are mandatory reading.  Better yet for fans of portfolio sleeves, the results kept clients afloat.  I’ve included the links below.  (Some may require a free Morningstar registration to read.)

Article:  A Bucket Portfolio Stress Test  http://news.morningstar.com/articlenet/article.aspx?id=605387&part=1

Article:  We Put the Bucket System Through Additional Stress Tests  http://news.morningstar.com/articlenet/article.aspx?id=607086

Article:  We Put the Bucket System Through a Longer Stress Test  http://news.morningstar.com/articlenet/article.aspx?id=608619

 

 

Posted by:


3 Keys to a Simple Investment Strategy

August 8, 2013

Simplicity is the ultimate sophistication.—-Leonardo di Vinci

This quotation doubles as the title of a Vanguard piece discussing the merits of a simple fund portfolio.  However, it occurred to me that their guidelines that make the simple fund portfolio work are the same for making any investment strategy work.  They are:

  • adopt the investment strategy
  • embrace it with confidence, and
  • endure the inevitable ups and downs in the markets

Perhaps this seems obvious, but we see many investors acting differently, more like this:

  • adopt the investment strategy that has been working lately
  • embrace it tentatively, as long as it has good returns
  • bail out during the inevitable ups and downs in the markets
  • adopt another investment strategy that has been working lately…

You can see the problem with this course of action.  The investment strategy is only embraced at the peak of popularity—usually when it’s primed for a pullback.  Even that would be a minor problem if the commitment to the investment strategy were strong.  But often, investors bail out somewhere near a low.  This is the primary cause of poor investor returns according to DALBAR.

Investing well need not be terribly complicated.  Vanguard’s three guidelines are good ones, whether you adopt relative strength as we have or some different investment strategy.  If the strategy is reasonable, commitment and patience are the big drivers of return over time.  As Vanguard points out:

Complexity is not necessarily sophisticated, it’s just complex.

Words to live by.

 

Posted by:


Correlation and Expected Returns

July 31, 2013

Modern portfolio theory imagines that you can construct an optimal portfolio, especially if you can find investments that are uncorrelated.  There’s a problem from the correlation standpoint, though.  As James Picerno of The Capital Spectator points out, correlations are rising:

A new study from the Bank of International Settlements (BIS) raises doubts about the value of commodities as a tool for enhancing portfolio diversification. The paper’s smoking gun, so to speak, is that “the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.”

Correlations are a key factor in the design and management of asset allocation, but they’re not the only factor. And even if we can find assets and strategies with reliably low/negative correlations with, say, equities, that alone isn’t enough, as I discussed last week. You also need to consider other factors, starting with expected return. It may be tempting to focus on one pair of assets and consider how the trailing correlation stacks up today. But that’s hardly the last word on making intelligent decisions on how to build a diversified portfolio.

As more investors pile into commodities, REITs, hedge funds, and other formerly obscure corners, the historical diversification benefits will likely fade. Granted, the outlook for expected diversification benefits fluctuates through time, and so what looks unattractive today may look considerably more compelling tomorrow (and vice versa). But as a general proposition, it’s reasonable to assume that correlations generally will inch closer to 1.0. That doesn’t mean that diversifying across asset classes is destined to become worthless, but the expected payoff is likely to dim with the passage of time.

Mathematically, any two items that are not 100% correlated will reduce volatility when combined.  But that doesn’t necessarily mean it’s a good addition to your portfolio—or that modern portfolio theory is a very good way to construct a portfolio.  (We will set aside for now the MPT idea that volatility is necessarily a bad thing.)  The article includes a nice graphic, reproduced below, that shows how highly correlated many asset classes are with the US market, especially if you keep in mind that these are 36-month rolling correlations.  Many asset classes may not reduce portfolio volatility much at all.

correlations36month zpsef265698 Correlation and Expected Returns

Source: The Capital Spectator  (click on image to enlarge)

As Mr. Picerno points out, optimal allocations are far more sensitive to returns than to correlations or volatility.  So even if you find a wonderfully uncorrelated investment, if it has a lousy return it may not help the overall portfolio much.  It would reduce volatility, but quite possibly at a big cost to overall returns.  The biggest determinant of your returns, of course, is what assets you actually hold and when.  The author puts this a slightly different way:

Your investment results also rely heavily on how and when you rebalance the mix.

Indeed they do.  If you hold equities when they are doing well and switch to other assets when equities tail off, your returns will be quite different than an investor holding a static mix.  And your returns will be way different than a scared investor that holds cash when stocks or other assets are doing well.

In other words, the return of your asset mix is what impacts your performance, not correlations or volatility.  This seems obvious, but in the fog of equations about optimal portfolio construction, this simple fact is often overlooked.  Since momentum (relative strength) is generally one of the best-performing and most reliable return factors, that’s what we use to drive our global tactical allocation process.  The idea is to own asset classes as long as they are strong—and to replace them with a stronger asset class when they begin to weaken.  In this context, diversification can be useful for reducing volatility, if you are comfortable with the potential reduction in return that it might entail.  (We  generally advocate diversifying by volatility, by asset class, and by strategy, although the specific portfolio mix might change with the preference of the individual investor.)  If volatility is well-tolerated, maybe the only issue is trying to generate the strongest returns.

Portfolio construction can’t really be reduced to some “optimal” set of tradeoffs.  It’s complicated because correlations change over time, and because investor preferences between return and volatility are in constant flux.  There is nothing stable about the portfolio construction process because none of the variables can be definitively known; it’s always an educated approximation.  Every investor gets to decide—on an ongoing basis—what is truly important: returns (real money you can spend) or volatility (potential emotional turmoil).  I always figure I can afford Maalox with the extra returns, but you can easily see why portfolio management is overwhelming to so many individual investors.  It can be torture.

Portfolio reality, with all of its messy approximations, bears little resemblance to the seeming exactitude of Modern Portfolio Theory.

Posted by:


Factor Performance and Factor Failure

July 30, 2013

Advisor Perspectives recently carried an article by Michael Nairne of Tacita Capital about factor investing.  The article discussed a number of aspects of factor investing, including factor performance and periods of factor underperformance (factor failure).  The remarkable thing about relative strength (termed momentum in his article) is the nice combination of strong performance and relatively short periods of underperformance that it affords the investor seeking alpha.

Mr. Nairne discusses a variety of factors that have been shown to generate excess returns over time.  He includes a chart showing their performance versus the broad market.

factorperformance zps037b7505 Factor Performance and Factor Failure

Source: Advisor Perspectives/Tacita Capital  (click on image to enlarge)

Yep, the one at the top is momentum.

All factors, even very successful ones, underperform from time to time.  In fact, the author points out that these periods of underperformance might even contribute to their factor returns.

No one can guarantee that the return premia originating from these dimensions of the market will persist in the future. But, the enduring nature of the underlying causes – cognitive biases hardwired into the human psyche, the impact of social influences and incremental risk – suggests that higher expected returns should be available from these factor-based strategies.

There is another reason to believe that these strategies offer the prospect of future return premia for patient, long-term investors. These premia are very volatile and can disappear or go negative for many years. The chart on the following page highlights the percentage of 36-month rolling periods where  the factor-based portfolios – high quality, momentum, small cap, small cap value and value – underperformed the broad market.

To many investors, three years of under-performance is almost an eternity. Yet, these factor portfolios underperformed the broad market anywhere from almost 15% to over 50% of the 36-month periods from 1982 to 2012. If one were to include the higher transaction costs of the factor-based portfolios due to their higher turnover, the incidence of underperformance would be more  frequent. One of the reasons that these premia will likely persist is that many  investors are simply not patient enough to stay invested to earn them.

The bold is mine, but I think Mr. Nairne has a good point.  Many investors seem to believe in magic and want their portfolio to significantly outperform—all the time.

That’s just not going to happen with any factor.  Not surprisingly, though, momentum has tended to have shorter stretches of underperformance than many other factors, a consideration that might have been partially responsible for its good performance over time.  Mr. Nairne’s excellent graphic on periods of factor failure is reproduced below.

factorfailure zps55a7cd1c Factor Performance and Factor Failure

Source: Advisor Perspectives/Tacita Capital (click on image to enlarge)

Once again, whether you choose to try to harvest returns from relative strength or from one of the other factors, patience is an underrated component of actually receiving those returns.  The market can be a discouraging place, but in order to reap good factor performance you have to stay with it during the inevitable periods of factor failure.

Posted by:


Alternative Beta

July 22, 2013

…has been discovered by the Wall Street Journal.  Recently, they wrote an article about better ways to index—alternative beta—and referenced a study by Cass Business School.  (We wrote about this study here in April.)

Here’s the WSJ’s take on the Cass Business School study:

The Cass Business School researchers examined how 13 alternative index methodologies would have performed for the 1,000 largest U.S. stocks from 1968 to 2011.

All 13 of the alternative indexes produced higher returns than a theoretical market-cap index the researchers created. While the market-cap index generated a 9.4% annualized return over the full period, the other indexes delivered between 9.8% and 11.4%. The market-cap-weighted index was the weakest performer in every decade except the 1990s.

The most interesting part of the article, to me, was the discussion of the growing acceptance of alternative beta.  This is truly exciting.

Indeed, a bevy of funds tracking alternative indexes have been launched in recent years. And their popularity is soaring: 43% of inflows into U.S.-listed equity exchange-traded products in the first five months of 2013 went to products that aren’t weighted by market capitalization, up from 20% for all of last year, according to asset manager BlackRock Inc.

And then there was one mystifying thing: although one of the best-performing alternative beta measures is relative strength (“momentum” to academics), relative strength was not mentioned in the WSJ article at all!

Instead there was significant championing of fundamental indexes.  Fundamental indexes are obviously a valid form of alternative beta, but I am always amazed how relative strength flies under the radar.  (See The #1 Investment Return Factor No One Wants to Talk About.)  Indeed, as you can see from the graphic below, the returns of two representative ETFs, PRF and PDP are virtually indistinguishable.  One can only hope that relative strength will eventually gets its due.

PDPvPRF zps323d99f1 Alternative Beta

The performance numbers above are pure price returns, based on the applicable index not  inclusive of dividends, fees, commissions, or other expenses. Past performance not indicative of future results.  Potential for profits accompanied by possibility of loss.  See www.powershares.com for more information.  

Posted by:


Factor Investing

July 18, 2013

Factor investing is one of the new frontiers in portfolio construction.  We love this trend because relative strength (known as momentum to academics) is one of the premier factors typically used when constructing portfolios.  The Technical Leaders ETFs that we construct for Powershares have really benefited from the movement toward factor investing.

Larry Swedroe recently wrote a glowing article on factor investing for Index Universe that serves as a good introduction.  His article is full of great points distilled from a paper in the Journal of Index Investing.  (The link to the journal paper is included in his article if you want to read the original source.)

The basic idea is that you can generate superior performance by building a portfolio of return factors.  A corollary benefit is that because some of the factors are negatively correlated, you can often reduce the portfolio volatility as well.  A couple of excerpts from his article should give you the flavor:

The evidence keeps piling up that investors can benefit from building portfolios that diversify across factors that not only explain stock market returns but that also generate superior returns.

The authors found that investors benefited not only from the exposure to each of the factors individually, but also from the low or negative correlations across these factors. The result was more efficient portfolios than ones that were concentrated in a market portfolio or in single factors.

They concluded: “The fact that momentum and value independently deliver market outperformance, with negatively correlated active returns and a low probability of simultaneous market underperformance, provides the motivation for pursuing a momentum and value diversification strategy.”

We concur with the research that shows momentum and value make a great pairing in a portfolio.  The table included in the article showed that these two factors were negatively correlated over the period of the study, 1979-2011.

What brought a smile is that Mr. Swedroe is a well-known and passionate advocate for “passive” investing.  Factor investing is about as far from passive investing as you can get.

Think about how a value index or relative strength index is constructed—you have to build it actively, picking and choosing to get the focused factor exposure you want.  What is a value stock at the beginning of one period may not be a value stock after an extended run-up in price, so activity is also required to reconstitute and rebalance the index on a regular basis.  Stocks that lose their high relative strength ranking similarly need to be actively replaced at every rebalance.  Whether the picking and choosing is done in a systematic, rules-based fashion or some other way is immaterial.

Market capitalization-weighted indexes, as a broad generality, might be able to “kinda sorta” claim the passive investing label because they don’t generally have to be constantly rebalanced—although the index component changes are active.  A factor index, on the other hand, might require a lot of activity to reconstitute and rebalance it on a regular schedule.  But that’s the point—the end result of the activity is focused factor exposure designed to generate superior performance and volatility characteristics.

And spare me the argument that indexing is passive investing.  Take a look at the historical level of turnover in indexes like the S&P 500, the S&P Midcap 400, the S&P Smallcap 600, or the Russell 2000 and then try to make the argument that nothing active is going on.  I don’t think you can do it.  The only real difference is that you have hired the S&P index committee to manage your portfolio instead of some registered investment advisor.  (In fact, the index committees typically incorporate some element of relative strength in their decisions as they dump out poor performers and add up-and-coming stocks.  Look at the list of additions and deletions if you don’t believe me.)  Certainly the level of turnover in a value or momentum index belies the passive label as well.

Index investing is active investing.

I think where passive investing advocates get confused is on the question of cost.  Index investing is often low-cost investing—and cost is an important consideration for investors.  I suspect that many fans of passive investing are more properly described as fans of low-cost investing.  I’m not sure they are really even fans of indexing, since research shows that many so-called actively managed funds are really closet index funds.  Presumably their objection is the big fee charged for indexing while masquerading as an active fund, not the indexing itself.  (But the same research suggests that an active fund that is truly active—one with high active share—is not necessarily a bad deal.)

Even a factor index is active by definition, but if it is well-constructed and low cost to boot, it might worth taking a close look at.

Posted by:


Stock Market Sentiment Surveys: AAII Edition

July 2, 2013

Greenbackd, a deep value blog, had a recent piece on the value of stock market sentiment.  Stock market sentiment surveys have been a staple of technical analysis for decades, ever since the advent of Investors Intelligence in the 1960s, so I was curious to read it.  The study that Greenbackd referenced was done by Charles Rotblut, CFA.  The excerpts from Mr. Rotblut that are cited give the impression that the results from the survey are unimpressive.  However, they showed a data table from the article.  I’ll reproduce it here and let you draw your own conclusions.

AAIIsentiment zpsb291a50e Stock Market Sentiment Surveys: AAII Edition

Source: Greenbackd   (click on image to enlarge)

From Greenbackd, here’s an explanation of what you are looking at:

Each week from Thursday 12:01 a.m. until Wednesday at 11:59 p.m. the AAII asks its members a simple question:

Do you feel the direction of the stock market over the next six months will be up (bullish), no change (neutral) or down (bearish)?

AAII members participate by visiting the Sentiment Survey page (www.aaii.com/sentimentsurvey) on AAII.com and voting.

Bullish sentiment has averaged 38.8% over the life of the survey. Neutral sentiment has averaged 30.5% and bearish sentiment has averaged 30.6% over the life of the survey.

In order to determine whether there is a correlation between the AAII Sentiment Survey and the direction of the market, Rotblut looked at instances when bullish sentiment or bearish sentiment was one or more standard deviations away from the average. He then calculated the performance of the S&P 500 for the following 26-week (six-month) and 52-week (12-month) periods. The data for conducting this analysis is available on the Sentiment Survey spreadsheet, which not only lists the survey’s results, but also tracks weekly price data for the S&P 500 index.

There are some possible methodological problems with the survey since it is not necessarily the same investors answering the question each week (Investors Intelligence uses something close to a fixed sample of newsletter writers), but let’s see if there is any useful information embedded in their responses.

The way I looked at it, even the problematic AAII poll results were very interesting at extremes.  When there were few bulls (more than 2 standard deviations from the mean) or tons of bears (more than 3 standard deviations from the mean), the average 6-month and 12-month returns were 2x to 5x higher than normal for the 1987-2013 sample.  These extremes were rare—only 19 instances in 26 years—but very useful when they did occur.  (And it’s possible that there were really only 16 instances if they were coincident.)

Despite the methodology problems, the data shows that it is very profitable to go against the crowd at extremes.  Extremes are times when the emotions of the crowd are likely to be most powerful and tempting to follow—and most likely to be wrong.  Instead of bailing out at times when the crowd is negative, the data shows that it is better to add to your position.

HT to Abnormal Returns

Posted by:


Value, Quality, and Momentum in a Single Portfolio

June 5, 2013

Larry Swedroe’s “Look at Value, Quality, and Momentum” article in IndexUniverse is a must-read for anyone looking to understand the benefits of factor-based investing.

One reason that combining the strategies adds value is correlation.

Specifically, signals in gross profits-to-assets and momentum are both negatively correlated with valuation ratios, and profitability and momentum have low correlation. Thus, they hold very different stocks.

Swedroe cites a study by Robert Novy-Marx covering the period 1963-2011 that looked at the results of building a portfolio consisting of a combination of value, profitability, and momentum:

Marx then looked at combining the value and profitability strategies with momentum in a single portfolio. Over the same July 1963-December 2011 period, he found that a dollar invested in the market would have grown to more than $80; a dollar invested in large-cap winners (momentum stocks) would have grown to $597; a dollar invested in cheap large-cap winners would have grown to $411; a dollar invested in profitable, cheap large-cap stocks would have grown to $572 dollars; and a dollar invested in profitable, cheap, large-cap winners would have grown to $955.

Given that trading costs are relatively low in large-caps, even if turnover for a combined strategy was fairly high, the strategy seems to hold great appeal given the size of the premium.

Citing a different paper by AQR Capital also on the topic of combining value, quality, and momentum, Swedroe stated the following:

Another benefit of the core approach is more consistent performance. AQR’s study, which covered the period since 1980 in the U.S. and since 1990 in international markets, found that a simple value portfolio experiences significant five-year periods of underperformance, while the core portfolio effectively eliminates any such episodes, outperforming the market in every five-year period historically.

The key here is that combining different winning return factors—including value, quality, and momentum—has historically greatly benefited an investor both from a cumulative performance perspective and also from a performance consistency perspective.  Both cumulative performance and performance consistency are critically important to a client.

Past performance is no guarantee of future results.

Posted by:


The Problem With Intrinsic Value

April 12, 2013

Howard Marks makes a compelling argument for using relative strength (without even referring to relative strength):

“If you are a value investor and you invest whenever you find a stock which is selling for one-third less than your estimate of intrinsic value, and you say, I don’t care about the macro, nor what I call the temperature of the market, then you are acting as if the world is always the same and the desirability of making investments is always the same. But the world changes radically, and sometimes the investing world is highly hospitable (when the prices are depressed) and sometimes it is very hostile (when prices are elevated).

“I guess what you are saying is we just look at the micro; we look at them one stock at a time; we buy them whenever they are cheap. I can’t argue with that. On the other hand, it is much easier to make money when the world is depressed, because when it stops being depressed, it’s like a compressed spring that comes back.

“…I think it is unrealistic and maybe hubristic to say, ‘I don’t care about what is going on in the world. I know a cheap stock when I see one.’ If you don’t follow the pendulum and understand the cycle, then that implies that you always invest as much money as aggressively. That doesn’t make any sense to me. I have been around too long to think that a good investment is always equally good all the time regardless of the climate.”

Buyers and sellers respond to the very same fundamental factors in very different ways depending on the environment.  A stock can be cheap (and get cheaper) for a long period of time until which time as there are more buyers than sellers and the price begins to rise.  Relative strength doesn’t even make an attempt to estimate intrinsic value.  To a relative strength strategy, the concept of intrinsic value is meaningless.  A security is worth whatever the market says it’s worth.  Relative strength models simply allocate to the strongest trends in the market and therefore avoid the potential problems of sitting around waiting for the market to come around to your way of thinking.

As Marks correctly points out, the world changes radically over time.  However, one constant is the law of supply and demand.

HT: Business Insider

Posted by:


Investment Manager Selection

April 12, 2013

Investment manager selection is one of several challenges that an investor faces.  However, if manager selection is done well, an investor has only to sit patiently and let the manager’s process work—not that sitting patiently is necessarily easy!  If manager selection is done poorly, performance is likely to be disappointing.

For some guidance on investment manager selection, let’s turn to a recent article in Advisor Perspectives by C. Thomas Howard of AthenaInvest.  AthenaInvest has developed a statistically validated method to forecast fund performance.  You can (and should) read the whole article for details, but good investment manager selection boils down to:

  • investment strategy
  • strategy consistency
  • strategy conviction

This particular article doesn’t dwell on investment strategy, but obviously the investment strategy has to be sound.  Relative strength would certainly qualify based on historical research, as would a variety of other return factors.  (We particularly like low-volatility and deep value, as they combine well with relative strength in a portfolio context.)

Strategy consistency is just what it says—the manager pursues their chosen strategy without deviation.  You don’t want your value manager piling into growth stocks because they are in a performance trough for value stocks (see Exhibit 1999-2000).  Whatever their chosen strategy or return factor is, you want the manager to devote all their resources and expertise to it.  As an example, every one of our portfolio strategies is based on relative strength.  At a different shop, they might be focused on low-volatility or small-cap growth or value, but the lesson is the same—managers that pursue their strategy with single-minded consistency do better.

Strategy conviction is somewhat related to active share.  In general, investment managers that are willing to run relatively concentrated portfolios do better.  If there are 250 names in your portfolio, you might be running a closet index fund.  (Our separate accounts, for example, typically have 20-25 positions.)  A widely dispersed portfolio doesn’t show a lot of conviction in your chosen strategy.  Of course, the more concentrated your portfolio, the more it will deviate from the market.  For managers, career risk is one of the costs of strategy conviction.  For investors, concentrated portfolios require patience and conviction too.  There will be a lot of deviation from the market, and it won’t always be positive.  Investors should take care to select an investment manager that uses a strategy the investor really believes in.

AthenaInvest actually rates mutual funds based on their strategy consistency and conviction, and the statistical results are striking:

The  higher the DR [Diamond Rating], the more likely it will outperform in the future. The superior  performance of higher rated funds is evident in Table 1. DR5 funds outperform DR1 funds by more than  5% annually, based on one-year subsequent returns, and they continue to deliver  outperformance up to five years after the initial rating was assigned. In this  fashion, DR1 and DR2 funds underperform the market, DR3 funds perform at the  market, and DR4 and DR5 funds outperform. The average fund matches market  performance over the entire time period, consistent with results reported by  Bollen and Busse (2004), Brown and Goetzmann (1995) and Fama and French  (2010), among others.

Thus,  strategy consistency and conviction are predictive of future fund performance  for up to five years after the rating is assigned.

The bold is mine, as I find this remarkable!

I’ve reproduced a table from the article below.  You can see that the magnitude of the outperformance is nothing to sniff at—400 to 500 basis points annually over a multi-year period.

diamondratings zps3970f53e Investment Manager Selection

Source: Advisor Perspectives/AthenaInvest   (click on image to enlarge)

The indexing crowd is always indignant at this point, often shouting their mantra that “active managers don’t outperform!”  I regret to inform them that their mantra is false, because it is incomplete.  What they mean to say, if they are interested in accuracy, is that “in aggregate, active managers don’t outperform.”  That much is true.  But that doesn’t mean you can’t locate active managers with a high likelihood of outperformance, because, in fact, Tom Howard just demonstrated one way to do it.  The “active managers don’t outperform” meme is based on a flawed experimental design.  I tried to make this clear in another blog post with an analogy:

Although I am still 6’5″, I can no longer dunk a basketball like I could in college.  I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either.  If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky?  Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense?  If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?

In other words, if you look for the right characteristics, you have a shot at finding winning investment managers too.  This is valuable information.  Think of how investment manager selection is typically done:  “What was your return last year, last three years, last five years, etc.?”  (I know some readers are already squawking, but the research literature shows clearly that flows follow returns pretty closely.  Most “rigorous due diligence” processes are a sham—and, unfortunately, research shows that trailing returns alone are not predictive.)  Instead of focusing on trailing returns, investors would do better to locate robust strategies and then evaluate managers on their level of consistency and conviction.

Posted by: