Momentum and Value Chronicles

March 30, 2011

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.

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Attention Asset Allocators

March 18, 2011

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.

Click here to receive the brochure on our Systematic Relative strength portfolios.  Click here for disclosures.

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Back to Reality

March 9, 2011

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.

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RS and Value: Enlightened Asset Allocation

January 14, 2011

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.

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Early New Year’s Resolutions for 2011

December 23, 2010

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.

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Value or Growth: Which is Better?

November 22, 2010

This isn’t exactly the topic of my post, but it’s an inquiry along those lines, and it probably got your attention.  My occasion for thinking about this was a comment in the Prudent Speculator newsletter, published by Al Frank Asset Management through Forbes.  John Buckingham is the chief investment officer, one of the most respected deep value investors around, and has the track record to prove it.  In addition, he is a super nice guy and a friend of mine.  John cited data from the Ibbotson Yearbook, compiled by Eugene Fama and Ken French, that indicated that value stocks had higher returns than growth stocks:

Certainly there have been periods (the 30s and 90s) during which value stocks have lagged growth, but data compiled by Eugene Fama and Ken French show that from 1928-2009, large value stocks had an 11.0% geometric return, compared to 8.7% for large growth, while small value stocks have outperformed by a wider margin (13.9% to 9.0%).

It is untrue that value outperforms growth, contradicted by both experience and statistics, but it is a popular misconception.  The misconception stems from the way in which value and growth are defined.  The Ibbotson Yearbook in question uses the book-to-market ratio as their metric.  This is probably the most common definition in the academic literature as well.  Value is virtuously defined as having high book-to-market values.  Growth is defined in opposition as those stocks with low book-to-market values.  In other words, growth is defined rather perversely as bad value! If growth is defined as bad value, it’s not too surprising that bad value performs worse than good value!

Our research assistant, J.P. Lee, went to the Ken French data library and looked at portfolios formed by market capitalization and book value.  The relationships are just as Ibbotson reported, although the numbers are slightly different because of different time periods and a slightly different methodology.  For the period from 1/30/1927 to 6/30/2010, large cap value (high book-to-market) stocks had a 13.0% compounded return, compared to 9.0% for large growth (low book-to-market/bad value).  Small value stocks outperformed by a wider margin (18.9% to 8.1%).  The charts below show the relationships.   (Click all charts to enlarge)

source: Ken French Data Library

Of course, growth investors don’t actually busy themselves trying to find overpriced stocks! John Brush has written a very important paper about this, Value and Growth, Theory and Practice, (archived on our website) which was published in 2007 in The Journal of Portfolio Management.  He points out that all the conventional academic definition shows is that good value beats bad value.  He proposes, instead, a list of ten selection factors to define the value and growth styles.

Dividend-to-price Short-term change in earnings-to-price
Earnings-to-price Long-term change in earnings-to-price
Cash flow-to-price Estimate revisions
Expected future earnings-to-price Earnings surprise
Book value-to-price Price momentum

source: John Brush, Journal of Portfolio Management

Note that the value factors are static, while the growth factors are dynamic.  As Brush puts it:

Most value managers will agree that the static factors describe their style.  Most growth managers will perhaps more reluctantly recognize the dynamic measures as the basis of their style.

Brush shows that annualized excess returns for un-rebalanced portfolios formed monthly for the period from 1971-2004 are higher for growth stocks over holding periods up to a year, then shift slightly in favor of value stocks for longer holding periods.  Of course, in real life, portfolios are not left unchanged for years at a time.  Evidence from actual mutual fund portfolios shows that growth stock returns are very similar to value stock returns, if not slightly ahead.  For example, John Bogle of Vanguard fame, in his 2003 book, Common Sense on Mutual Funds, writes:

In recent years, the conventional wisdom has been to give the value philosophy accolades for superiority over the growth philosophy. Perhaps this belief predominates because so few observers have examined the full historical record…For the full 60-year period, the compound total returns were: growth, 11.7 percent; value, 11.5 percent – a tiny difference.

Relative strength is a growth factor. Academics refer to it as price momentum, which is how you will find it listed in the table above.  We think it is the most powerful growth factor, and also the most adaptable.  Because of its incredible adaptibility, we use relative strength exclusively to manage portfolios.  When you compare high relative strength to value, suddenly the tables are turned.  Keep in mind that the charts below are generated from the exact same Ken French data library.  Value is still defined as high book-to-market, the same data definition that made growth/bad value look like such a nebbish in the last set of charts.  But this go round, growth/bad value has been replaced with a worthier opponent, high relative strength.

source: Ken French data library

When it is a fair fight, it’s pretty clear that relative strength is not inferior to value at all. Large cap high RS stocks had a 14.9% compounded return, compared to 13.0% for large cap value.  Relative strength also outperformed in the small cap arena, with compounded returns of 20.0%, compared to 18.9% for small cap value.

And, as it turns out, relative strength and value are quite complementary.  Their excess returns tend to be uncorrelated, a fact that is remarked on both in Bogle’s book and Brush’s article.  Any advisor that has been in the business for a while has seen this effect–both value and growth go through pronounced cycles.  Now that we know that both relative strength and value are powerful return factors, and that their excess returns are uncorrelated, what are the practical implications for an advisor?

1) If relative strength is the premier growth factor, it might make sense to replace the growth managers in your stable with managers that use relative strength.

2) Since the excess returns from relative strength and value are uncorrelated, it might make sense to expose clients to both return factors.  Brush’s article suggests that a 50/50 mix is the best combination.

So which is better, value or growth?  The truth is none of the above.  Both are valuable return factors for a portfolio–and because they tend to offset one another, they are even better in combination.  If you like, think of the client’s portfolio as a Milky Way bar.  Chocolate is good; so is caramel.  And together, mmm!


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Using Momentum To Help Mitigate Risk

September 7, 2010

Writing in Pensions & Investments magazine, Khalid Ghayur summarizes the merits of combining momentum and value strategies:

While research has shown that value stocks outperform the market over the long run, value strategies can underperform significantly during shorter periods. Capturing the full extent of value returns requires a long-term commitment on the investor’s part. However, periods of pronounced underperformance often negatively affect investors’ ability to “stay the course.”

Our research documents that a highly diversified strategy that combines value stocks with high price-momentum stocks (i.e., stocks with a high trailing 12-month total return) offers important risk reduction benefits to investors. It allows investors to stay invested for the long term by significantly mitigating potential underperformance in the short term.

Academic research has documented that value and momentum have provided significant market outperformance, or active returns, over the long run. Value and momentum are powerful and persistent sources of active returns, as depicted in the chart below.

My emphasis added.  We’ve written a lot in the past about what a good portfolio mix relative strength and momentum make together. This article just makes the same point.  There’s another important issue embedded in his article that ought to be of interest to advisors still using style boxes.  He mentions that “momentum serves as a better diversifier to value than growth.”  In terms of portfolio construction, you may be better off with value and relative strength than with value and growth.  This viewpoint is likely to become more widespread, because as Mr. Ghayur points out:

Not surprisingly, Morningstar Inc. recently announced it soon will begin giving stocks a momentum score and then use it to give mutual funds a momentum ranking. This may ultimately lead to a new momentum investment style category for mutual funds.

Why wait for a mutual fund?  You can be the first advisor on your block to use our already-available Systematic Relative Strength portfolios, which are separate accounts designed to capture momentum returns. Alternatively, there are three PowerShares Technical Leaders indexes designed to capture momentum returns.  I must admit, though, that it’s nice to see industry leaders like Morningstar coming around to our point of view!

To receive the brochure for our Separately Managed Account strategies, click here.  More information about PDP can be found at

Click here for disclosures.  Past performance is no guarantee of future returns.

Click here to read the entire article, including the results of combining a value and momentum strategy from 1940-2009.

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Who Makes Money In The Markets?

September 3, 2010

Derek Hernquist on who makes money in the markets:

Who makes money in the markets?  Sometimes it’s the guy with the opinion, and he gets books written about him like John Paulson.  Good for him…I think it was more about the low risk/high reward purchase he made on those credit default swaps, but his prediction paid off.

Generally two types of investors make money over time…value investors and momentum investors.  Why?  Because they’re willing to act when most aren’t. Their success doesn’t hinge on predicting an outcome…it hinges on someone later paying a much higher price than you pay now.  The value investor scours the balance sheet, develops a thesis on what “fair value” is, and if it’s well enough below, buys the stock and waits.  If fundamentals improve, it’s a home run instead of a double…but the payoff is not contingent on that outcome.

On the other spectrum, the momentum investor looks at rising price or explosive growth and joins in…seems silly, but since most are afraid to pay up there’s actually only a small % of participants aboard.  He’s not making a prediction, he’s making an observation…this thing is going up, and I’m going to be involved until it stops going up.  Simple, but often effective as most are too worried they missed the boat already…how many people do you know that have actually owned NFLX or CRM or BIDU for more than a week?

Full disclosure: Dorsey Wright owns NFLX, CRM, and BIDU.

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Stock Market Investing: Not for Cupcakes

June 7, 2010

Investors are quite skittish these days.  2001-2002 was bad enough, but then 2008 came along.  Most investors lost a boatload of money, in some cases enough to get them to swear off investing altogether.  Although that may be understandable from a certain perspective, it’s probably not the way to go.  The reality is that market volatility is to be expected.  Charlie Munger, Warren Buffett’s investing partner at Berkshire Hathaway, rather unsympathetically expounds on what investors should expect (my emphasis added):

“I think it’s in the nature of long term shareholding of the normal vicissitudes, of worldly outcomes, of markets that the long-term holder has his quoted value of his stocks go down by say 50%. In fact you can argue that if you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder and you deserve the mediocre result you’re going to get compared to the people who do have the temperament, who can be more philosophical about these market fluctuations.”

I’ve seen plenty of people react to a 50% decline, but not usually with equanimity!  The always excellent Psy-Fi blog has this further comment:

Munger is, as usual, spot on the money. It turns out that the odds of a 50% drawdown in any investor’s portfolio during an investing lifetime are virtually 100%. Dabble in stocks for long enough and you’re bound to lose half your net worth in a single swoop. In some recent research Guofu Zhou and Yingzi Zhu have set about demolishing the idea that our most recent set of calamities are surprising.

In other words, what markets are going through right now–although it’s clearly the unpleasant part–is just part of the normal cycle of investing.  The problems come when investors  create drama over what should be expected.  It might be healthier to imagine one’s portfolio as having a wide range of possible values, as opposed to taking mental ownership of the equity value reflected on your best monthly statement.  Psy-Fi has a couple of suggestions for reducing the unnecessary drama:

…intelligent investors should mange their holdings with the expectations that they’ll lose 50% of their value at some point. The main aim should be to ensure that such a drawdown is a temporary measure and, if you’re invested in good enough stocks, this should surely prove to be the case over a few years. This is the lesson of behavioural finance: be humble in the face of the markets, diversify wisely and don’t use leverage.

That’s a pretty good prescription: 1) think long term, 2) diversify effectively between strategies, and 3) don’t use leverage.  Patience always helps, because drawdowns in most sound strategies are temporary.  Diversification between strategies (not necessarily just asset classes) can help mitigate drawdowns too.  We find, for example, that high relative strength strategies blend nicely with deep value strategies.  Finally, the absence of leverage gives you the staying power to hold on during a drawdown.  Too much borrowed money, as some overleveraged homeowners are finding out, will cause you to mail in the key to your portfolio to the margin clerk at an inopportune time.

Investing is a rough game; you’ve got to be tough to play.  To paraphrase Yogi Berra, “Investing is 90% mental, the other half is rational.”

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A Recipe for Success

April 28, 2010

Everyone wants to have a top-performing manager.  That’s the whole point of hiring a manager, right?  No one intentionally hires a manager that lags.  The difficulty comes about when good managers have temporary periods of underperformance.  How do you know it’s temporary?  Should you fire the manager and switch, or should you stick with them through the period of underperformance?

The traditional method of dealing with this issue has been to terminate managers who underperform over some intermediate time period, say three years, and to then replace them with a manager that outperformed over that time period.  As has been shown amply in the research literature, the traditional method doesn’t work.  In the inimitable words of the Psy-Fi blog,

What the plan sponsors are doing, like many behaviorally compromised individuals, is chasing returns in the same way a retriever brings back a lit stick of dynamite.

Some resources are provided in this article on the Psy-Fi blog, which deals with behavioral issues in finance.  For instance, there is a link to a paper on pension funds hiring and firing practices that shows how poorly this strategy–which is in fact used by most funds–works in actual practice.   In fact, doing the opposite tends to work better!

The Brandes Institute has also addressed manager selection and performance chasing.  Psy-Fi points out:

…as Death, Taxes and Short-term Underperformance shows, the probability is that even the best managers will go through significant periods of poor returns. Studied over a decade even the top performing funds managed, on average, to underperform the S&P500 by over 8% during at least one three year rolling period. One (unnamed) fund managed to trail the index by over 40% in one year. All of the top five performing funds managed to underperform at some point during the decade. 53 out of 59 funds appeared in the bottom 10% of performers during at least one quarter and 10 of them managed this for a rolling three year period.

This complicates the picture quite a bit.  It becomes clear that even very good managers, for whatever reason, have significant periods of underperformance, although that doesn’t stop them from outperforming over the longer term.  Psy-Fi equates short-term performance with noise:

Basically firing a fund manager because of a couple of years of poor performance is simply shooting them because you don’t like noise in the system.

We all know that short-term performance may not be indicative of the longer run, but how do we decide?  How do we distinguish between signal and noise?

From a practical standpoint, it seems to me that the investor has to rely on some kind of tested return factor.  If a return factor has worked in the past, especially for a very long time, it seems more likely that it will continue to work in the future–even if there is enough noise in the system to create short-term underperformance from time to time.

There aren’t a lot of candidates for return factors that have worked over long periods of time.  Many studies, both practitioner and academic, suggest that value and relative strength are the main return factors that have outperformed over many decades.  Both factors are robust and work in numerous formulations, but both factors also move in and out of favor–essentially creating the noise that Psy-Fi talks about. 

Happily, it turns out that value and relative strength as strategies are not very correlated.  AQR Capital Management makes a strong case for blending  relative strength and value, as the two strategies are largely complementary.  From a client standpoint, then, the best recipe for success might be to find a disiplined relative strength manager (us, we hope!) and a disciplined value manager.  Apportion the account appropriately and let bake for Warren Buffett’s favorite holding period–forever.

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Podcast #1 – The New Frontier in Asset Allocation

April 23, 2010

DWAMM’s Podcast 1 – The New Frontier in Asset Allocation: Mixing Strategies, Not Assets Mike Moody and Andy Hyer

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DWA Podcast

May 20, 2009

John Lewis, Tom Dorsey, & Tammy DeRosier discuss market leadership coming out of bear markets, time horizons required for investing in relative strength strategies, and ideas of how to position relative strength strategies as part of an asset allocation.

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