Our partners at Arrow Funds have published an excellent piece that makes the case for combining Value and Momentum. Click here to access the article. The great thing about this particular article is that it make the case not just with statistics (which are very compelling), but it also clearly explains the rationale for using Momentum as a Growth replacement in very non-technical terms.
Israel, Frazzini, Moskowitz, and Asness address (aggressively!) the critics of momentum investing in what is one of the best white papers I have read on the topic. Absolute must-read.
Abstract:It’s been over 20 years since the academic discovery of momentum investing (Jegadeesh and Titman (1993), Asness (1994)), yet much confusion and debate remains regarding its efficacy and its use as a practical investment tool. In some cases “confusion and debate” is us attempting to be polite, as it is near impossible for informed practitioners and academics to still believe some of the myths uttered about momentum — but that impossibility is often belied by real world statements. In this article, we aim to clear up much of the confusion by documenting what we know about momentum and disproving many of the often-repeated myths. We highlight ten myths about momentum and refute them, using results from widely circulated academic papers and analysis from the simplest and best publicly available data.
Click here to download.
Posted by: Andy Hyer
Let’s say that you have reviewed enough of the body of work on momentum to have concluded that momentum is able to generate excess returns over time and that you want to employ it in your investments. Now what—where does it fit in an allocation? As much of the research indicates, momentum is more highly correlated to growth than it is to value. Therefore, you might think of it in terms of a way to diversify your portfolio from value.
Further insight comes from this study published by RBC Capital Markets in 2011 that points out that since the 1930s, momentum has outperformed value, growth, and the S&P 500. Value also outperformed the S&P 500, but growth underperformed them all.
Yet, how many allocations remain diversified between growth and value when they might be better off by replacing their growth exposure with momentum?
For example, consider the growth of two sample portfolios from July 1995 – November 2013. One portfolio is 50% Russell 1000 Growth and 50% Russell 1000 Value. The other portfolio is 50% Momentum and 50% Russell 1000 Value.
Source: Russell Investments, Ken French Data Library: Momentum Portfolio is Top Half Market Cap, Top Third Momentum
Over this period of time, the Growth/Value portfolio had an annualized return of 8.84% while the Momentum/Value Portfolio had an annualized return of 11.25%. It is also noteworthy that the standard deviation was virtually identical for this time frame: 15.85% for the Growth/Value portfolio and 15.84% for the Momentum/Value Portfolio. For comparison, the S&P 500 had an annualized return of 8.72% and standard deviation of 15.61% over this same time frame.
So where does momentum fit in a portfolio? Try replacing your growth exposure with momentum and see if your results don’t improve over time.
Dorsey Wright is the index provider for a suite of Momentum ETFs with PowerShares.
Past performance is no guarantee of future returns. All results above include dividends, but do not include any transaction costs.
Posted by: Andy Hyer
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 persist—they 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: Mike Moody
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: Mike Moody
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: Andy Hyer
Morningstar does a pretty deep dive into momentum in their article Does Momentum Investing Work? I highly recommend reading the whole article as it covers some excellent long-term studies of momentum. It also has a nice profile of our PowerShares DWA Technical Leaders ETF (PDP).
While practitioners have been exploiting this relationship for decades, the idea has gained broad acceptance in the academic community only within the past 20 years. Momentum runs counter to the predictions of the efficient market hypothesis, but the evidence is too overwhelming to ignore.
Included in their article was the following study of momentum on U.S. and global stocks:
The tables below illustrate the momentum effect among large-cap U.S. and global stocks. Each column represents a fifth of the total number of stocks in the sample, which are ranked by their momentum. While there is not a linear relationship between the momentum quintiles, stocks with the highest momentum consistently outperform those in the lowest momentum quintile. Small-cap stocks tend to exhibit a stronger momentum effect. However, they can be more expensive to trade.
I also enjoyed this part about how the persistence of excess returns from momentum strategies continues to baffle people:
This evidence creates a puzzle. If the market were efficient, a simple trading rule should not produce superior returns. Arbitrage is a powerful force that should eliminate any excess profits, and yet, momentum has persisted 20 years after it was first widely published. Perhaps more troubling to disciples of Ben Graham and Warren Buffett, momentum appears to be at odds with decades of research, which suggest that stocks trading at low valuations tend to outperform.
The article also makes a strong case for why momentum makes a better companion for value than does growth:
In their paper, “Value and Momentum Everywhere,” Asness, Moskowitz, and Pedersen found that momentum worked well when value didn’t, and vice versa. Because they are two sides of the same coin, each with excess returns, combining value and momentum in a portfolio can offer powerful diversification benefits.
It’s not necessary, or advisable, to abandon value investing to benefit from momentum. Instead, momentum may be a good substitute for investors’ growth allocations. Momentum offers higher expected returns than growth and tends to be less correlated with value. The chart below compares the performance of a portfolio consisting equal weights in the Russell 1000 Value and Growth indexes, with a portfolio that replaces the growth allocation with the AQR Momentum Index. The two portfolios have similar volatility, but the value and momentum portfolio offers slightly better absolute and risk-adjusted returns.
Finally, I agree with Morningstar’s assessment of why the excess returns from momentum are likely to persist:
While a diversified and systematic momentum strategy can offer a powerful way to enhance returns, selecting a few stocks on the 52-week high list is a very bad idea. It is difficult to anticipate when a run will end and there may be no greater fool to bail you out. Although momentum is a short-term phenomenon, it is best suited for long-term investors. It won’t always work, but there’s a good chance that a disciplined momentum strategy will continue to outperform over the long term. After all, investor behavior won’t change overnight.
HT: Abnormal Returns
Posted by: Andy Hyer
IndexUniverse recently profiled two relatively new value ETFs (TILT and VLU):
Who needs another value-oriented ETF? Maybe you.
SSgA launched the SPDR S&P 1500 Value Tilt ETF (NYSEArca: VLU) in late October, bringing a second choice to a somewhat-overlooked corner of the U.S. equity space.
VLU, along with the more-established FlexShares Morningstar U.S. Market Factor Tilt ETF (NYSEArca: TILT), aren’t your typical value funds. VLU just launched and TILT is a $150 million fund that came to market about a year ago.
The typical style fund sorts the equity universe into value and growth stocks using fundamental ratios. These ratios can include price-to-earnings and price-to-book among others. But, the most basic distinction is that the typical value funds hold some stocks but not others. For example, an S&P 500 value fund might hold about 250 stocks.
Funds like VLU and TILT use a different approach. They hold all of the stocks in the universe but give the value stocks more weight.
This is good news that more factor-based ETFs are coming to market. In fact, I hope to see even more variations of value-based ETFs launched because it presents a great opportunity for investors who are looking to diversify by return factors as opposed to by style box. Our criticism of style box investing is that, because style boxes tend to be highly correlated, the diversification benefits are limited. Readers can click here to read different articles that we have written over the years about the potential benefits of combining relative strength (a trend continuation strategy) and value (a mean reversion strategy).
There isn’t yet much price history for VLU, but TILT has now been out for over a year. Using monthly returns, I was interested to see that PDP (DWA Technical Leaders ETF) and TILT have had a correlation of excess returns of -0.07. Not bad, but I look forward to finding value ETFs that have an even lower correlation of excess returns to relative strength. Finding different winning return factors that also have negative correlation of excess returns looks to be very promising for investors who are seeking to build diversified portfolios.
See www.powershares.com for more information about PDP.
Posted by: Andy Hyer
Justice: Do we live in a world where there’s no room for growth funds?
Asness: If you define growth the way a lot of the world does as simply the opposite of value, then no, there’s not a lot of room for growth funds. There will be probably occasions where value is offering you so little, you want to look at growth, and that could happen, but it’s pretty rare, because the average value premium is fairly large, so you have to be in a pretty extreme situation where you’d want to tactically allocate toward the opposite of value, or growth.
Frankly, we believe that momentum is correlated to growth, but that it’s a better style. Growth being the opposite of value means it has a negative passive premium, a negative long-term premium. Momentum, like growth, is negatively correlated to value but has a positive premium over time.
The name of the game in this business is to find sources of return that, at the least, do not perfectly correlate with each other; it’s even better if they are uncorrelated with each other, and in a wonderful world, are negatively correlated with each other.
Momentum and value are two positive sources of return that are negatively correlated with each other.
Read more on this topic in The Case for Momentum Investing by Adam Berger, Ronen Israel, and Tobias Moskowitz.
Posted by: Andy Hyer
Our Technical Leaders Indexes were prominently profiled in New Factor-Based Strategies Make ETFs Less Passive by Rosalyn Retkwa in Institutional Investor magazine.
Exchange-traded funds increasingly seek to rebalance their portfolios without bastardizing the concept of passive investing.
The article also includes quotes by Tom Dorsey and Mike Moody:
Invesco PowerShares of Wheaton, Illinois, offers four ETFs based on the DWA Technical Leaders index created by Dorsey Wright & Associates of Richmond, Virginia. That index measures the relative strength or momentum in stocks to pick out the top 100 stocks in three categories — large- and midcap U.S. stocks (PDP), developed markets ex-U.S. (PIZ), and emerging markets (PIE) — and the top 200 small-cap stocks (DWAS). All four are reweighted quarterly. “We could have chosen weekly or monthly, but quarterly worked out the best for us in our test,” says Tommy Dorsey, a principal in the firm, emphasizing that the selection of the “leaders” is all machine-driven, “with no human intervention. What’s taken out of the equation is human emotion. It’s all rules-activated.” Dorsey believes that ETFs “should stop short of being active and trying to compete with mutual funds,” because once they become actively managed, “you have that emotion, and that’s where the ETF has become bastardized,” he says.
But “people are experimenting and trying a lot of different things,” says Mike Moody, a senior portfolio manager at Dorsey Wright Money Management, the Pasadena, California–based asset management arm of the Richmond firm. “In just the last few years, there’s been an explosion with both academics and practitioners discussing how factor-based returns combine in a portfolio,” he says. “The dominant method for a long time has been characterizing equity through style boxes — small cap, large cap — and they’re all pretty highly correlated, but if you take that universe and you add in factors like low volatility and relative strength, they don’t have the same correlation,” he says.
See www.powershares.com for more information.
Posted by: Andy Hyer
Professor Mark Perry at the University of Michigan cites the following study to prove that active management is a loser’s game:
CBS Money Watch: “Twice each year, Standard & Poor’s puts out its active versus passive investor scorecard, reporting on how actively managed funds have done against their respective benchmark indexes. Every time, the results are pretty much the same, demonstrating that active management is a loser’s game – in aggregate those playing leave on the table tens of billions of dollars forever seeking alpha (outperformance, adjusted for risk).”
The following is a summary of the latest scorecard’s findings:
- For the five years ending March 2012, only 5.23% of large-cap funds, 5.46% of mid-cap funds and 5.14% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
- Looking at longer-term performance, 5.97% of large-cap funds with a top-quartile ranking over the five years ending March 2007 maintained a top-quartile ranking over the next five years. Only 4.35% of mid-cap funds and 15.56% of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.
Obviously, the majority of investors in active funds are taking all the risks of investing and not being properly rewarded for taking those risks, transferring tens of billions from their accounts to the wallets of active managers. The question is why do they keep doing this? Evidence suggests that one explanation is that they are simply unaware of how poorly they are doing.”
According to Professor Perry, active management is only a success if it outperforms in each 12-month period. I know of a number of return factors that have outperformed over time, but I know of nothing that outperforms in every single period.
In related news, Michael Jordan is now considered to be a loser because he did not win the NBA championship in every year he played.
Posted by: Andy Hyer
Thanks to the large amount of stock data available nowadays, we are able to compare the success of different strategies over very long time periods. The table below shows the performance of two investment strategies, relative strength (RS) and value, in relation to the performance of the market as a whole (CRSP) as well as to one another. It is organized in rolling return periods, showing the annualized average return for periods ranging from 1-10 years, using data all the way back to 1927.
The relative strength and value data came from the Ken French data library. The relative strength index is constructed monthly; it includes the top one-third of the universe in terms of relative strength. (Ken French uses the standard academic definition of price momentum, which is 12-month trailing return minus the front-month return.) The value index is constructed annually at the end of June. This time, the top one-third of stocks are chosen based on book value divided by market cap. In both cases, the universes were composed of stocks with market capitalizations above the market median.
Lastly, the CRSP database includes the total universe of stocks in the database as well as the risk-free rate, which is essentially the 3-month Treasury bill yield. The CRSP data serves as a benchmark representing the generic market return. It is also worthwhile to know that the S&P 500 and DJIA typically do worse than the CRSP total-market data, which makes CRSP a harder benchmark to beat.
Source:Dorsey Wright Money Management
The data supports our belief that relative strength is an extremely effective strategy. In rolling 10-year periods since 1927, relative strength outperforms the CRSP universe 100% of the time. Even in 1-year periods it outperforms 78.6% of the time. As can be seen here, relative strength typically does better in longer periods. While it is obviously possible do poorly in an individual year, by continuing to implement a winning strategy time and time again, the more frequent and/or larger successful years outweigh the bad ones.
Even more importantly, relative strength typically outperforms value investment. Relative strength defeats value in over 57% of periods of all sizes, doing the best in 10-year periods with 69.3% of trials outperforming. While relative strength and value investment strategies have historically both generally beat the market, relative strength has been more consistent in doing so.
Posted by: Amanda Schaible
March 1, 2007 was the day that Tom Dorsey rang the bell at the New York Stock Exchange as PowerShares launched the PowerShares DWA Technical Leaders ETF (PDP). Later that year, two international versions of the index were launched (PIE and PIZ). So, how have they done? Click here to find out (financial professionals only). This video makes the case for relative strength, explains how we construct the PowerShares DWA Technical Leaders Indexes, and provides some ideas for how to include them in an asset allocation.
See www.powershares.com for more information.
Posted by: Andy Hyer
Portfolio construction has typically relied on strategic asset allocation to help control volatility. The idea is that if you combine assets with low correlations, you can significantly reduce the volatility of your returns. Lately, however, correlations have become a problem. Jeff Benjamin, writing in Investment News, discusses the problem:
Asset classes have become so highly correlated over the past few years that many traditional diversification strategies have lost their effectiveness.
For example, take the link between growth and value stocks.
For the decade ended December 2000, the correlation between the Russell 1000 Growth Index and the Russell 1000 Value Index was just 57%. During the decade ended this past December, it jumped to 92%.
For a more extreme case, compare the correlation of the MSCI Emerging Markets Index with the Russell growth index. The former was negatively correlated to the latter by 6% — which was great for those seeking diversification — in the decade through December 2000, but the correlation spiked to 89% in the following decade.
You can see the issue—drastically changing correlations will move your efficient frontier far from where you imagined it was.
Some of the observers Mr. Benjamin quoted were blunt:
“Traditional diversification is like a seat belt that only works when you’re not in a car accident,” said Michael Abelson, senior vice president of investments at Genworth Financial Wealth Management Inc.
“Depending on risk tolerance, we might recommend allocating half a portfolio to a diversified strategic strategy and then 30% to 35% to a tactical strategy and 15% to 20% to alternatives,” Mr. Abelson said.
Besides having a knack for a fine turn of phrase, Mr. Abelson mentions something that we have noticed more and more in recent years. It used to be the case that tactical allocation was used as a satellite strategy and might get only a 10% slice of a portfolio. Now, we often see the tactical strategy with a 35-50% weight. Some advisors are even using the tactical allocation as the core strategy and arranging alternatives and other asset classes as strategic overweights.
With the rise of tactical allocation come new challenges. Chief among them is how to manage the tactical portion of the portfolio. All-in/all-out timing decisions are notoriously difficult to get right. Overweighting and underweighting based on valuation requires sophisticated modeling that must be constantly updated. In addition, many assets are resistant to traditional valuation methods.
One method that does work over time is tactical asset class rotation using relative strength. We’ve chosen that path for our Global Macro strategy because it allows a very large and diversified universe to be ranked on the same metric. That, and because it works.
Posted by: Mike Moody
Numerous academic studies, some archived on our website, suggest that outsized returns can be achieved over time by purchasing cheap stocks with high relative strength. In fact, James O’Shaughnessy highlighted this in What Works on Wall Street as one of the best strategies over the past 50 years. Lost in all of the hullabaloo over Apple’s dividend, oil prices, Iran, and so on is the fact that the market is undervalued—and has been for most of the past year, according to Morningstar’s fair value estimates.
Source: Morningstar (click on image to enlarge)
What I know about valuation methodologies could probably fit on the head of a pin, but that’s what Morningstar’s analysts do all day. When they look at where stocks are selling relative to their estimates of fair value, the market as a whole—and even most sectors—is still undervalued.
Retail investors have been incredibly reluctant to re-engage with the stock market since being burned in 2008-2009. For a couple of years now, much more investor money has been flowing to bond funds than stock funds. I’m just not sure if that is a rational move when stocks are undervalued.
Posted by: Mike Moody
The early editions of James O’Shaughnessy’s bible What Works on Wall Street identified two combination strategies that were so good that mutual funds were formed to implement the strategies. Cornerstone Value was a large cap dividend strategy, while Cornerstone Growth combined value with relative strength. The funds have been around since 1996 or so. CXO Advisory poses the question:
Has 14 years of out-of-sample performance of these two mutual funds confirmed the motivating backtests?
HFCVX [Hennessy Cornerstone Value] underperforms both its benchmark Russell 1000 Value Index and the S&P 500 Index. The fund underperforms the S&P 500 Index by about 0.5% per year, compared to the backtested average annual outperformance of about 7%. Also, its standard deviation of annual returns (20.1%) is higher than that for the benchmark Russell 1000 Value Index (18.7%). Backtested outperformance has not persisted over a 14-year out-of-sample implementation.
HFCGX [Hennessy Cornerstone Growth] outperforms both its benchmark Russell 2000 Index and the S&P 500 Index. The fund outperforms the S&P 500 Index by about 2.5% per year, compared to the backtested average annual outperformance of about 10%. Its standard deviation of annual returns (21.2%) is about the same as that for the benchmark Russell 2000 Index (21.1%). Backtested outperformance has persisted at a subdued level over a 14-year out-of-sample implementation.
Source: CXO Advisory
In other words, the dividend strategy has not been able to beat the market over the last 14 years, while the relative strength strategy has outperformed in real life. This mirrors CXO’s findings earlier. I might note that the outperformance of the Cornerstone Growth strategy comes despite the Q3-Q4 2008 – Q1-Q2 2009 performance of relative strength, which was a big historical outlier. The underperformance of relative strength was epic during that brief period—and Cornerstone Growth outperformed anyway. I would further note that the 2.5% annual outperformance is after fees.
Evidence suggests that relative strength is a strategy worth implementing.
Posted by: Mike Moody
Building good portfolios for clients is a critical task for advisors. Creating an artful mix of stocks, bonds, and alternatives can make a big difference for returns and for client comfort. James Picerno, writing in Financial Advisor, discusses how new factor indexes have the potential to change traditional asset allocation. Speaking about the availability of many new factor indexes in ETF form, he writes:
The broader message is that indexing is moving past the standard beta carve-ups, such as small- vs. large-cap equities and value vs. growth stocks. A new era of factor-based indexing is dawning, and it promises to be far more nuanced and complicated.
Adding factor allocation to the traditional asset allocation framework certainly widens the possibilities for adding value. More risk factors equates with a richer opportunity set for exploiting the rebalancing process.
A study last year in The Journal of Portfolio Management lists more than a dozen factors, including volatility, momentum, earnings yield, currency sensitivity and interest-rate sensitivity. Several exhibit persistence and generate risk premiums, advises “On the Persistence of Style Returns” (by Stan Beckers of BlackRock and Jolly Ann Thomas at UBS). “More interestingly,” they report, “an active style overlay could have added significant value to the market index.”
Mr. Picerno quotes one especially enthusiastic observer.
“It’s a quantum leap in terms of engineering the portfolio,” says Harindra de Silva, president of Analytic Investors, a quantitative money manager in Los Angeles. “I think you’ll move from asset allocation to factor allocation.”
I don’t know if Mr. de Silva’s forecast will come to pass, but it’s clear that traditional asset allocation is changing. I think advisors will adopt factor allocation if it allows them to productively fine tune their client’s exposures. If it turns out that there is no practical advantage to factor allocation then it might not catch on. More experience with some exotic factor indexes may be needed to learn how to use them most effectively.
In the meantime, there’s already evidence of a good way to improve your core equity exposure by combining relative strength with value. This isn’t the first time we’ve written on this topic, but I think it is not being widely implemented. Relative strength is a trend continuation factor and value tends to be a trend reversal factor. Combining the two works extremely well because the excess returns from the two strategies are uncorrelated.
Correlations between assets can vary greatly, but correlations between strategies that are dynamic opposites are much more stable. Replacing growth-oriented equities with high relative strength stocks to match off against your value exposure is something that you can do to improve your core equity allocation today.
Posted by: Mike Moody
The always-terrific Barron’s has a nice interview with Dennis Stattman, head of the Blackrock Global Allocation Fund, one of our value-oriented competitors in the global asset allocation arena. He’s done a terrific job for many years, and his value-oriented approach turns out to be a very good complement to our relative strength approach. (For full articles on this topic, see Global is the New Core and The “All-in-One Fund” With a Twist.) For me, the highlight of the interview was this exchange about the role of global go-anywhere funds:
Barron’s: There’s been a lot more money flowing into asset-allocation funds that can invest in many different styles, including the fund you run. What’s your take on this trend?
It isn’t surprising that the category is growing in popularity. It reflects the frankly dismal job that the most popular category, equity-only mutual funds, have done, as shown by the dismal results they have delivered to investors over long periods of time. They just haven’t provided a good risk-return trade-off. Furthermore, the idea that somebody can buy six different U.S. stock funds and somehow achieve useful diversification just isn’t an effective idea. It never was a good idea, and now it has been proved wrong. So having the ability to go anywhere is what, ideally, a fund manager should have. But there are very, very few individuals or teams who have the experience and who are equipped to do this.
I wholeheartedly concur with his remark on style-box diversification being completely inadequate, but I think the problem is not with equity-only mutual funds, but rather reflects the issue of poor portfolio construction. Too often portfolio construction has focused on assets (as in asset allocation) on not on diversification by strategy. Value and relative strength work well together because they are essentially strategic opposites: relative strength is trend following, and value is mean-reverting. It’s not too surprising that their excess returns are uncorrelated, but that makes them a wonderful blend for a client portfolio.
Lots of clients own Blackrock Global Allocation, but how many of them know how much their portfolio can potentially be improved with the addition of our Global Macro strategy?
To obtain a fact sheet and prospectus for the Arrow DWA Tactical Fund (DWTFX) or the Arrow DWA Balanced Fund (DWAFX), click here.
Posted by: Mike Moody
For decades the investment industry has embraced the concept of mixing growth and value. This is based on the idea that because the two styles are not perfectly correlated there are diversification benefits possible by mixing the two.
However, we frequently make the case that investors are likely to achieve better results by replacing their growth exposure with momentum. Others have also made this case. In fact, click here for an excellent white paper by AQR Capital on the topic.
As an illustration, consider the chart below which compares the performance of a momentum/value combination and a growth/value combination.
(Click to Enlarge)
Source: Ken French Data Library*, Russell Investments
The momentum index is based on an index maintained at the Ken French Data Library and is composed of US stocks from the top half of capitalization and top third of momentum in his universe. As shown above, $100 in the momentum/value combination turned into $423 while $100 in the growth/value combination turned into only $292.
Sorry, growth…momentum is just a better fit.
Posted by: Andy Hyer
Maybe I’m overstating the case slightly, but I will note that buying the dips is a favorite strategy of retail investors. They feel like sophisticated contrarians going against the grain. How better to get street cred as a value investor?
Professionals, on the other hand, have other names for this strategy, replete with terms like knife catching, javelin catching, and catching the falling safe.
Morningstar puts to rest, hopefully for good, the dubious wisdom of trying to be a knee-jerk contrarian. The results were decidedly negative. Sorry, all you javelin-catchers:
As you can see in the table below, buying the dips hurt returns in stocks, real estate, and currencies, but not long-term U.S. government bonds. The losses are big and exceedingly unlikely to be random events. An investor who bought the S&P 500 on dips and sold into rallies would have lagged the benchmark by 2.3% annualized since 1926. The chance of suffering such underperformance by randomly selecting months to buy the index is less than 1%.
Source: Morningstar (click to enlarge)
Ouch. So how does that happen? If something is a value, isn’t it supposed to be better when it falls in price? Yes—if you’ve worked up the proper valuation—which is a tricky thing not easily done. And bear in mind:
It’s possible for an asset to shed dollars and still be overpriced.
This isn’t surprising in light of momentum (aka relative strength), according to Morningstar:
The pervasive underperformance of our short-term dip-buying strategy isn’t surprising to those familiar with price momentum (sometimes abbreviated MOM in academia). The tendency for prices to trend can be tremendous. In 1993, Narasimhan Jegadeesh and Sheridan Titman published a study showing that holding the top 10% of U.S. stocks ranked by trailing 12-month returns and shorting the bottom 10%, rebalanced and reconstituted monthly, earned excess returns of 1% a month from 1965 to 1989, or more than 12% annually. The study spurred a frenzy of research that documented momentum in virtually all stock markets and asset classes, including the Victorian-era British stock market. Thanks to this rich body of research, we have a decent idea of why momentum exists and how it behaves.
To be fair, professional investors who are building valuation models often get it right, especially over a long time frame. But I’ve yet to see a retail investor work up a valuation spreadsheet. And without one, you’re probably going to get nailed:
If you’ve done the hard work of calculating an asset’s intrinsic value, and dips bring the price below intrinsic value, the strategy is a rational exercise in value investing. However, without that legwork, dip-buying is a remarkably bad technical trading rule.
I added the bold. If you are a retail investor without a valuation spreadsheet it seems a little dangerous to compete with the professionals by trying to buy the dips.
The point is, if you are going to try to trade technically, it seems far more rational to focus on relative strength. Relative strength works across virtually all markets and asset classes and has done so for a remarkably long period of time. The trend is your friend, until it ends.
Posted by: Mike Moody
Cliff Asness of AQR Capital has a new white paper out, Momentum in Japan: The Exception that Proves the Rule, that is well worth the read. He convincingly makes the case “that because value and momentum strategies are strongly negatively correlated, they need to be studied as a system.” See the table below for value and momentum correlations around the world over the past 30 years.
As is detailed in the paper, both value and momentum strategies have been able to generate excess return all over the world. Even in Japan, where the returns to momentum strategies have not been nearly as large as they have been in the rest of the world, the benefits of combining value and momentum remain robust.
Those advisors who are seeking to construct asset allocations that are likely to provide excellent risk-adjusted returns over time should be all over this concept of mixing value and momentum.
Posted by: Andy Hyer
For this commentary on asset allocation I’ll start with the widely understood justification for asset allocation and then move on to a less well-known concept that has some important implications for those using relative strength strategies.
A fundamental justification for asset allocation is the notion that different asset classes offer returns that are not perfectly correlated, hence diversification reduces the overall risk in terms of the variability of returns for a given level of expected return. Therefore, having a mixture of asset classes is more likely to meet the investor’s wishes in terms of the amount of volatility and possible returns. Asset classes such as stocks, bonds, real estate, commodities, and currencies are typically employed to construct an asset allocation.
However, many financial advisors stop there. Many think of US stocks as one asset class, bonds as one asset class, real estate as one asset class and so on. Such thinking leaves a lot on the table. What if US stocks can be broken down into several viable asset classes? Does this not have the potential to further improve the benefits of asset allocation? For example, this must-read white paper by AQR Capital makes it clear that value and relative strength are two complementary strategies. Remember that both strategies profiled in that white paper select securities from the same universe of U.S. stocks.
Anyone who goes to our website sees the following:
High relative strength stocks have historically provided high returns, but they often do not correlate very well with the broad market. For that reason, high relative strength stocks frequently appear to act like a separate asset class. From an asset allocation perspective, there is significant value in a high-return asset class that is uncorrelated with most other stocks and bonds. Non-correlated performance can help smooth out the returns in a diversified portfolio.
To demonstrate this point, consider the R-squared of our Systematic Relative Strength Aggressive portfolio (which invests in U.S. stocks) to the S&P 500.
Remember that the R-squared statistic gives the variation in one variable explained by another. It is computed by squaring the correlation coefficient between the dependent variable and independent variable (S&P 500 in this case). As shown in the table, 60% of the variation in our Systematic RS Aggressive portfolio can be attributed to the S&P 500 (therefore, 40% of it is not). This means that even though we are fishing from the same pond (although this portfolio can also invest in mid-cap US stocks) the variation of the performance is quite different from that of the S&P 500. In fact, this portfolio has a lower R-squared to the S&P 500 than the Russell 2000 (small cap US stocks), MSCI EAFE (developed international stocks), MSCI Emerging Markets, and the Dow Jones Real Estate Index! This is not a typical result—where the S&P 500 is more correlated to foreign markets than it is to another portfolio composed entirely of domestic securities! A more typical result may be found when looking at the five most popular equity funds, where their R-squared averages 0.96, according to Morningstar.
How can this happen? Well, relative strength identifies those securities that have strong intermediate-term relative strength out of a universe of securities. Often, those securities with the best relative strength are not the stocks that have the biggest influence on the movement of the S&P 500.
All financial advisors are in the asset allocation business. Some do it well. Some do it poorly. I would suggest that including relative strength strategies in your asset allocations has the potential to be very helpful from a performance and diversification perspective.
Posted by: Andy Hyer
Chuck Jaffe of Marketwatch included the following in a recent article:
In times like these, pros like to say “it’s a stock-picker’s market,” but that’s ridiculous, because it’s always a stock-picker’s market. While a rising tide can lift all stocks and turn even bad strategies into money-makers, savvy strategies and insights never go out of style.
Interesting. I’d love to find the “savvy strategies” that never go out of style! Unfortunately, Bernie Madoff is currently unavailable.
Back to reality. It is no secret that relative strength and value are two strategies that have shown the ability to generate outperformance over time. However, both of them do go out of favor from time to time. Fortunately, the correlation of these two strategies tends to be quite low over time. We are big advocates of combining the two winning strategies as a way to mitigate some of the underperformance when one or the other is temporarily out of favor.
Posted by: Andy Hyer
Several months ago, Mike made the case for replacing your traditional growth strategies with relative strength. For anyone in this business who is looking to add value through asset allocation, that post is a must read.
See the chart below for an example of this concept in action.
(Click to Enlarge)
Source: Ken French Data Library and Russell Investments
The red line is a 50/50 mix of the Russell 1000 Growth Index and the Russell 1000 Value Index. Combining growth and value has been industry practice for decades and chances are that most advisors follow this approach to asset allocation. However, a more enlightened approach would be to combine relative strength and value. The blue line is a 50/50 mix of a Ken French momentum index and the Russell 1000 Value Index. The data for the Ken French momentum index is taken from his online data library. That particular momentum index consists of stocks from the top half of market cap from his universe and the top third of relative strength. His index is rebalanced monthly. As shown in the chart, much higher returns were earned by mixing relative strength and value rather than the traditional approach of mixing growth and value.
Past performance is no guarantee of future returns.
Posted by: Andy Hyer
Money is not the most important thing in life, but it’s right up there with oxygen.—-Dennis Miller
For those of you who like to get an early start on your resolutions, I have a list of things that might positively impact your financial well-being. Admittedly, this is the season when most Americans are preoccupied with spending money, but maybe it’s not a bad idea to also think about preserving and growing it.
1. Hire a good financial advisor. You might know a little more about what is going on, and you could end up with a lot more money. At least that was the conclusion from a recent study of 14,000 adults by ING Retirement Research.
According to the data, those who spent some time with an advisor reported saving, on average, more than twice as much for retirement as those who spent no time at all with an advisor. The number jumped even higher – over three times as much – for those who spent a lot of time with an advisor.
And yet the usage rate of advisors for this sample was a significant minority, only 31%.
2. Save more. You’re going to need it, because you are probably going to live a lot longer than you think. You’ve seen all of the statistics about how little Americans have saved or stashed into their 401ks. Do something about it. Bump your 401k savings rate up a couple of percentage points for next year. If you’re already maxing it out, start an automatic investment plan with a good mutual fund. (I am biased toward the Arrow DWA Balanced Fund!) Yes, you! Do it now before you forget about it.
3. Identify a good return factor and exploit it. Mercilessly. Relative strength and value are the most prominent return factors that have proven themselves over time. Better yet, create a portfolio that uses them both, because they mesh together very nicely.
4. Persist. Markets are going to be uncomfortable at times. You’ve got to stick with a strategy through thick and thin to reap the best returns. It’s most important not to abandon a sound strategy when it is really uncomfortable–that’s what causes investors to perform poorly.
5. If you must listen to the financial media at all, consider going opposite the accepted wisdom. A market is only news when it’s at an extreme–and that’s usually the time to consider going against the grain.
If you decide to get into shape and lose a few pounds also, great. Here’s a link to a Wall Street Journal article about how to stick to your resolutions. It’s all worthwhile.
Posted by: Mike Moody