Systematic Relative Strength

Bill Hester, CFA of Hussman Funds recently wrote a very insightful article about the convergence of the global financial market performance that began in the second half of the 1990s and then the growing divergence seen in recent months:

For a brief period during the last decade the developed economies around the world became one. Countries shared similar fiscal policies, interest rate policies, and spending patterns which resulted in uncharacteristically similar economic performances. Investors took their cues from these trends and sent financial market securities converging in price and yield. The range of bond yields tightened, the level of valuations became closely aligned, and trailing stock returns were remarkably similar. As the developed economies continue to recover from the world-wide credit crisis, and now face new pressures of over-levered sovereign balance sheets and the prospects for below-average economic growth, investors should expect financial market performance among countries to continue to diverge.

(Bold is my emphasis)

Included in his article was the graph below which shows the spread between the highest and lowest 6-month returns of the members of Morgan Stanley’s index of developed countries (the spread is smoothed to highlight the medium-term cyclical fluctuations of the series).

Source: Hussman Funds

The large spread around 1990 highlights the weakness in the Nordic countries during this period as their stock markets collapsed as they battled their domestic banking crises. The peak around 2000 coincides with the peak in the world-wide stock market bubble where a few indexes that were over-weighted in telecommunication and technology stocks fueled strong relative outperformance. But even outside of those peaks, the graph shows that during the 1970′s and 1980′s it was typical for there to be large divergences between the best and worst performing countries – 40 to 50 percentage points difference was typical. More recently through 2007 the divergence in stock market returns among developed countries collapsed. There was very little value in making distinctions at the country level when individual country returns were so tightly centered about broad benchmark return levels.

These trends have shifted the last couple of years and the recent spread between relative performances continues to widen. Year to date, Denmark’s benchmark index is up 20 percent, while the Athens Stock Exchange index has dropped 33 percent. Country selection is beginning to matter again.

This divergence is potentially a very favorable development for global relative strength strategies.  In any universe of securities there is a dispersion or bell curve of returns with the bulk of the returns huddled around the mean and then a number of extreme positive outliers and a number of extreme negative outliers.  The goal of relative strength strategies is to focus the portfolio on the positive outliers and to avoid the extreme negative outliers.  The greater the dispersion in returns, the more likely relative strength is to be able to deliver superior performance over a benchmark index fund. If we do indeed see much greater divergence in country returns going forward, relative strength is well-positioned to capitalize.

Financial advisors will often categorize their book of business in order to be able to more efficiently structure their business efforts.  It is common practice for financial advisors to categorize their book into “A,” “B,” and “C” clients.  The A clients are generally those with the largest assets and tend to be the best source of referrals.  The B clients have potential and may one day turn into A clients.  Finally, the C clients make up that portion of an advisor’s book of business that may have smaller account balances (often in the range of $50,000 – $250,000 of liquid assets.)  The A clients tend to get the most specialized attention and the C clients tend to get the least.  However, just because the C clients tend to get the least amount of specialized attention from the financial advisor does not mean that they are not personally important to the advisor.  Furthermore, the C clients can represent both a current and future meaningful piece of business for the advisor.  I would suggest that many C clients throughout the industry feel neglected by their financial advisor and I would also suggest that the quality of financial advice and portfolio execution is often not up to par with that which is provided to the A clients.  This need not be so.

Several years ago, we brought a strategy to the market that I believe is an ideal solution for this portion of an advisor’s book of business: The Arrow DWA Balanced Fund (DWAFX.)  This global tactical asset allocation strategy invests in U.S. equities, international equities, fixed income, and alternative investments.  The allocations are driven by a systematic relative strength process that seeks to overweight the portfolio in those asset classes with the best relative strength. However, this strategy will always maintain a minimum amount of exposure in each of the asset classes in order to buffer the volatility and as a way to mitigate the amount of underperformance experienced during major changes in asset class leadership. The ranges of exposure in the strategy are shown in the table below:

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There are 4 reasons why this is the ideal solution for the C clients.

1. Within one portfolio an investor is able to achieve broad diversification across multiple asset classes.
2. The strategy is designed to benefit from shifting exposure to those asset classes with the best relative strength.  However, it always maintains at least some exposure in each of the asset classes at all time in order to buffer the volatility and to mitigate the underperformance during major changes in asset class leadership.  As a result, there tends to be less hand-holding required by the financial advisor.
3. There is no need for the financial advisor and the client to meet periodically in order to “re-balance” the portfolio.  All re-balancing is done on an ongoing basis and is driven in a disciplined fashion by relative strength.
4. It is likely to be an easy sell, given the excellent performance of the strategy since its inception in August of 2006.  As can be seen in the table below, the fund is outperforming 97% of its peers YTD, it is outperforming 79% of its peers MTD, it is outperforming 67% of its peers over the last twelve months, and it is outperforming 90% of its peers over the last three years.

Source: Morningstar, updated through 6/16/10

To get a feel for how this fund adapts over time, see the charts below which show the allocations to each of the different asset classes from December of 1998 to date.  (Data before the fund’s inception of 8/9/06 is based on hypothetical returns.)  You can click the images to enlarge them.

The Sector rotation portion of the strategy can invest in the following sectors: Basic Materials, Consumer Goods, Consumer Services, Energy, Financial Services, Healthcare, Industrials, Technology, Telecom, and Utilities.

The Style rotation portion of the strategy can invest in the following styles: Large Cap Growth, Large Cap Value, Mid Cap Growth, Mid Cap Value, Small Cap Growth, and Small Cap Value.

The International rotation portion of the strategy can invest in the following countries: Australia, Austria, Belgium, Brazil, Canada, China, France, Germany, Hong Kong, India, Israel, Italy, Japan, Malaysia, Mexico, Netherlands, Singapore, South Africa, South Korea, Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, and the U.K.

The Fixed Income rotation portion of the strategy can invest in the following: Aggregate Bonds, Corporate Debt: Short Term, Intermediate, and Long Term, Govt. Agencies, U.S. Treasurys: T-Bills, Notes, and Govt. Bonds.

The Alternative rotation portion of the strategy can invest in the following: Commodities: Aggregated, Agriculture, Energy, Industrial Metals, Precious Metals, Softs, Currencies, REITs, and TIPs.

To obtain a fact sheet and prospectus for the Arrow DWA Balanced Fund (DWAFX), click here or call Jake Griffith at 301-260-0163.

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

Our endowment-type portfolio, the Arrow DWA Balanced Fund (DWAFX), has been smoking its peers in the Morningstar Moderate Allocation Category.  It is in the 5th percentile YTD (outperformed 95% of its peers), 14th percentile over the past month (outperformed 86% of its peers), 32nd percentile over the past year (outperformed 68% of its peers), and it is in the 15th percentile over the past three years (outperforming 85% of its peers.) Performance through 6/14/10. Not too shabby.

Source: Morningstar

This global balanced fund invests in U.S. stocks, international stocks, fixed income, and alternative investments.  For more information about the Arrow DWA Balanced Fund (DWAFX), please go to www.arrowfunds.com.  Past performance is no guarantee of future returns.

The WSJ’s Jason Zweig points out that last week, the Dow Jones Industrial Average rose above 10,000-again.  Since March 16, 1999, when it first touched 10,000 in intraday trading, the Dow has bounced over that threshold and back 63 times.  Friday, the index closed 219.6 points below where it stood exactly 11 years ago.

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Source: www.stockcharts.com

This isn’t the first time stocks have been stuck on a seemingly endless pogo-stick ride.  On Jan. 18, 1966, the Dow hit an intraday high of 1,000.50.  It broke through the four-digit barrier three more times that January and Febrary, then faded.  The Dow cracked 1,000 again in 1972 and 1976, then fell back both times.  Not until December 1982 did the Dow finally hurdle above 1,000 and stay there.

History is under no obligation to repeat itself exactly, but this comparison does beg the question of how long before the Dow Jones Industrial Average will meaningfully rise from the 10,000 level.  The fluctuations around Dow 1,000 persisted for 17 years.  We have been fluctuating around Dow 10,000 for 11 years.  Periods of extended Dow stagnation can test the patience of even the most forbearing equity-only investor.

One way to deal with this U.S. equity stagnation is to employ an investment strategy that has the flexibility to shift into many different asset classes in order to find those asset classes that are currently in secular bull markets.  This is exactly the objective of our Global Macro strategy which tactically overweights those asset classes with the best relative strength.  Consider the table below which shows the average allocation to each of the major asset classes since mid 1999:

Every major asset class goes through periods of extended stagnation – it is just part of the cyclical nature of the financial markets.  Rather than making permanent commitments to any one asset class, we find it more prudent to employ a flexible global asset allocation strategy that keeps our options open.

Global Macro is available as a separately managed account.  To receive a brochure, please click here.  Global Macro is also available as the Arrow DWA Tactical Fund (DWTFX).

Click here to visit www.arrowfunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.  Past performance is no guarantee of future results.

One characteristic of bubbles that lends itself to being exploited by trend-following methodologies is that bubbles generally unfold over the span of several years or more.  This can be seen in the charts below of bubbles in various stock, currency, and commodity markets. These dynamic moves gain speed and often spike higher in the final year or two of the move before they begin their descent.  Trend-following strategies, like relative strength, are designed to start participating early enough in the move that the money made during the ascent more than compensates for the losses experienced during the trend deterioration phase. Once the change in trend has become sufficiently apparent, trend-following strategies exit the trade and begin the search for the next dynamic move.

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Source: James Montier, GMO Asset Management

The advantage of a global tactical asset allocation strategy is its ability to seek out dynamic trends in a wide variety of asset classes and thereby increasing the probabilities of more consistent returns.

Ezra Klein’s recent interview with uber-economist Ken Rogoff included the following interesting exchange:

You said that there are indicators we can watch to predict when we’re vulnerable to a financial crisis, but in general, the problem is that policymakers explain the indicators away. Information, in other words, is not enough, because people create stories to explain the information away.

Start with a really important point: It’s very hard to call the timing of a crisis. You can see that an economy is vulnerable, and maybe even fairly reliably say you’ll have a crisis in 5 to10 years, but until it’s upon you, it’s hard to narrow the window down with any precision. Many of the people who say they predicted the crisis in a precise way had actually been predicting a crisis for years. There’s irreducible uncertainty coming from fragile confidence and political factors. The analogy is someone who’s vulnerable to a heart attack. You can go to the doctor and they can see your cholesterol is high and you have a number of risk factors, but you might go on for 20 years without anything happening. Or it might be 20 hours.

Because the timing is hard to call, policymakers have trouble getting seized by it. Why worry if it is not going to hit on my watch? And if you’re an investor and you’re making great money for five more years and then you have a bad year, you still have a good decade. But policymakers, especially, need to have a longer vision because of the human cost of financial crises, particularly in the hugely elevated level of long-term unemployment.

Investing is always disconcerting because of the real and perceived risks to the capital markets and to the global economy.  Professor Rogoff’s point about timing a financial crisis based on known fundamental data is an important one.  Risks may be in place to cause a crisis, but if the likely window of time for those risks to actually result in crisis range from the next couple months to the next several decades the investor is left with the decision of how to incorporate those known risks into an investment plan.  It is one thing to be aware of great fundamental risks and it is another to be able to translate that knowledge into profitable investment returns.

Again, we see why pragmatists gravitate to tactical asset allocation.  The tactical asset allocator accepts the reality that timing market moves based on fundamental data is nearly impossible.  Therefore, the tactical asset allocator embraces the concept of reacting to trends in a disciplined fashion.  It is the next best thing to having a crystal ball.

For your “Why I Use Trend Following” file:

From the Harvard Business Review:

For the past quarter century, equity analysts’ earnings-growth estimates have been almost 100% too high. Their overoptimistic projections have generally ranged from 10% to 12% annually, compared with actual growth of 6% (excluding the spike in growth from 1998–2001), according to McKinsey research. Only in strong-growth years such as 2003 to 2006 did forecasts hit the mark.

HT: Crossing Wall Street

Strategic asset allocation has been the most prominent form of asset allocation for decades now.  It is a lovely theory and makes for a slick presentation for a client.  But, there’s a problem with it.  A very big problem.  Strategic asset allocation models rely on historical inputs (returns, correlations, and variances) of different asset classes  to generate an allocation that “maximizes the return for a given level of risk.”  Relying on historical statistical relationships, a strategic asset allocation model can propose just how much of a portfolio should be allocated to US equities, international equities, currencies, commodities, real estate, and fixed income.  The most common method for generating the required inputs for a strategic asset allocation model is to use a long-term data set, say 50 or 75 years.  This will give you a stationary data point for each of the inputs.  Strategic asset allocation will work just fine, as long as the future consistently looks just like each of those stationary inputs.  This might happen.  It never has in the past, but it might…

The chart below might just be the single best way to explain the benefits of tactical asset allocation over strategic asset allocation.

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Source: Arrow Funds

These efficient frontiers of bonds and equities have been all over the map!  Each decade was a little, or a lot, different.  You can use 75 years worth of data to tell you about the average statistical relationship, but this may do you little good over the next 10 or 20 years.  Financial professionals can click here, and then click on Global Macro Presentation to see an alternative approach to asset allocation.

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.  Past performance is no guarantee of future results.