4 Attributes of Those Advisors Who Employ Relative Strength

December 16, 2014

I am of the belief that there are certain shared attributes of those advisors who gravitate to relative strength investing.  My first experiences in this industry, as an intern at a brokerage firm in Denver, CO in the summer of 2001 made this clear and it has been repeatedly confirmed since that time.  Just in the first couple weeks as an intern, I became aware that some advisors are pre-occupied with the hunt for the bragging rights that come with buying some obscure stock that rises from the ashes like the phoenix.  They will invest in stocks that have very weak relative strength, losing money and time, waiting almost without condition for the chance of being proven right.  Other advisors concerned themselves almost solely with raising assets and managing relationships.  They farmed all the money out to their firm’s recommended money managers.  When times were good for these advisors, they were great.  And when they were bad, they were awful.  Not having much depth when it comes to how to construct a well-thought-out asset allocation has its downside—specifically, losing the confidence of their clients over time.  Other advisors, bought into the strategic asset allocation models constructed by their firm.  They would say, ‘Let’s face it, who am I to think I can compete with the brightest money managers in this industry?’  Those strategic asset allocation models certainly weren’t disasters.  They were ok, but they didn’t do much to leave their clients with the feeling that there was anything special about their financial advisor.

However, that summer and in the years since I have had many experiences that have allowed me to get to know advisors who are drawn to relative strength investing.  In some ways, these advisors have very little in common—they come from every geographic location, many different educational backgrounds, many different firms, etc.  However, they do tend to have the following attributes:

Pragmatic: While some are greatly impressed with the pundit who told everyone to get out of the market in October 2007 because there was a massive bear market coming, this advisor looks further and realizes that the pundit also told everyone to get out of the market in 2003, 2005, 2009, 2011…  While some are greatly impressed with Modern Portfolio because it is so elegantly taught in textbooks in Business schools around the country, this advisor asks about MPT’s track record.   When this advisor reviews the body of knowledge of relative strength investing, he sees results.  He sees it isn’t perfect and that it has periods of underperformance, but he is impressed with the weight of the evidence in its favor.

Process-Oriented:  Focus on process and the results will take care of themselves.  This is a philosophy that appeals to this advisor.  This advisor is looking to stack the odds in their favor.  They have seen the studies that make it clear that there is momentum in the market and that the best probability of finding a future winner is to buy a current winner and stay with it as long as it remains strong.  They look at stock selection in the context of portfolio management rather than as isolated trades.

At Peace with What They Can’t Control:  Relative strength is a trend following methodology.  By definition, you will never buy a security at the exact bottom or get out at the exact top.  This advisor has come to terms with this and they don’t bother themselves with finding the elusive crystal ball.  That crystal ball doesn’t exist.  Nobody knows what the future holds.  Pretending that you do, or that you can find someone who can, is madness.  However, what this advisor knows is that having a crystal ball is not necessary to succeed in this industry.  This advisor has also come to terms with the reality that certain environments are not favorable for relative strength strategies—namely, choppy trendless markets and markets with major reversals in leadership.  So what if it doesn’t work all the time.  Does it work most of the time?  Do you expect it to work over time?  Those are the right questions.

Competitive:  This advisor want to do right by their client.  They want to make a great living.  They want to generate favorable investment results over time.  And they conclude that relative strength is framework within which they will operate in order to achieve those goals.

If you are already using relative strength, chances are that those attributes do a good job of describing you.  If you don’t currently use relative strength, but are attracted to those attributes, then I recommend that you give it a closer look.

The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Quote of the Week

December 10, 2014

George Soros, Soros Capital Management

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

HT: Business Insider

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Quote of the Week

November 25, 2014

Via Alpha Architect:

Any third-rate engineer or researcher can increase complexity; but it takes a certain flair of real insight to make things simple again. –E.F. Shumacher

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The Implications of Manager Tenure

November 20, 2014

Nick Kirrage of Pieria recently wrote about portfolio manager tenure—a key data point for many advisors when selecting a fund.  This data happened to be for the UK, but I suspect that the data would be similar for the U.S.

When it comes to evaluating funds, just how important a consideration is fund manager tenure – that is to say, the length of time somebody has been at the helm of a particular portfolio? It is a question that crops up with a fair degree of frequency – including at a recent investment conference organised by Citywire and at which we were speaking.

An electronic voting system enabled the audience of UK-based financial advisers to express their thoughts on the matter and the overriding view turned out to be that, yes, fund manager tenure was a very important consideration. It also emerged that the audience members themselves had averaged around two decades of experience as financial advisers so how did fund managers do by comparison?

Not great, would be the short answer while the slightly longer one can be seen in the chart below. It plots, courtesy of data Citywire holds on its universe of 17,000-odd funds, the experience levels of fund managers – from the 91.1% who can boast a whole 12 months in charge of a portfolio to the 1.1% able to match the 20 years or so averaged by that audience of advisers.

starter for tenure chart The Implications of Manager Tenure

It is striking how steep the drop-off rate becomes over time, with under a fifth of fund managers surviving to celebrate their tenth anniversary. This has to play on some managers’ minds and may help to explain the index-hugging and consensus views so often seen in investment. Unfortunately, doing what is right by your investors is not always consistent with doing what might keep you in your job.

It is often said that “financial products are sold, not bought.”  In other words, very few individual investors wake up one morning and say to themselves, “Today, I am going to buy a global tactical asset allocation strategy.”  They may wake up knowing that they would like to see their money grow and risk management is very important to them, but in terms of selecting a product to help them achieve that objective they usually don’t have any idea of how to go about selecting a particular strategy.  Of course, that is why there are financial advisors.  However, what the above data on manager tenure reveals is that the rationale that was used by an advisor and an individual client to select a given investment fund in the first place may only hold true for a very short period of time.  Most portfolio managers have a given approach to managing a particular strategy.  For example, if the portfolio manger considers himself to be a “value manager,” what are the chances that there will be consistency in investment strategy for the fund when/if that portfolio manager decides to take a different job?  Even if the manager stays with the fund for a long period of time, what are the chances that the same investment process employed today will be the same process employed in five years?  Surely another function of a good financial advisor is to stay on top of the strategies being used for their clients and to make changes in managers when they deem necessary.  However, the reality is that the manager/investment strategy employed at a given fund may be constantly changing.  I don’t think most investors have much awareness of that fact.

These are among the very reasons that at Dorsey Wright we place such emphasis on process, consistency, and on building and executing rules-based models.  If someone were to ask me how the investment process for our Systematic RS International portfolio has changed since it was launched in April of 2006, the answer would be that nothing has changed.  Same for PDP, PIE, and PIZ and other investment strategies that we manage.  In full disclosure, very occasionally we will uncover something in our testing that we believe will result in meaningful improvement in the strategy and we reserve the right to make such a change.   Additionally, the line-up of guided ETF models (available at www.dorseywright.com) offer advisors a repeatable process for managing a client’s money.

Every advisor in this business is in competition for assets.  Educating clients and prospects about the systematic nature of the Dorsey Wright investment methodology can go a long ways towards helping you set yourselves apart from the competition.  Of course, we are not the only investment manager that employs a systematic investment process (think about the array of Smart Beta strategies).  But the larger point should be clear, consistency is a not a commodity in ample supply and yet it just may be among the most important considerations for any strategy.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  The relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Nothing contained herein should be construed as an offer to sell or the solicitation of an offer to buy any security.  The article does not attempt to examine all the facts and circumstances which may be relevant to any product or security mentioned herein.  We are not soliciting any action based on this document.  It is for the general information of clients of Dorsey, Wright & Associates, LLC (“Dorsey, Wright & Associates).  This document does not constitute a personal recommendation or take into account the particular investment objectives, financial situation, or needs of individual clients.  Before action on any analysis, advice or recommendation in this document, clients should consider whether the security or strategy in question is suitable for the particular circumstances and, if necessary, seek professional advice.

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Quote of the Week

November 10, 2014

Ben Carlson (A Wealth of Common Sense):

It’s difficult for intelligent people, especially in the world of finance, to admit that less is more and simple can be a far more effective framework than complex for the majority of investors. Some view this as an admission of ignorance. In fact, I view it as the ultimate sign of intelligence.

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Tweet of the Week

October 27, 2014

wesbury Tweet of the Week

Sometimes (all the time in our case) it is best to not to overthink things and to just systematically follow the trends.

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Stock vs. Company

October 23, 2014

Former Microsoft CEO, Steve Ballmer: During time that our market cap went from $500 billion to $200 billion our profit tripled from $9 billion to $28 billion.  Start watching at the 33:18 mark.

Good reminder that there can be a difference (sometimes very large!) between the stock and the company.

msft Stock vs. Company

Source: Yahoo! Finance

This example is presented for illustrative purposes only and does not represent a past recommendation.

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Do You Feel Lucky?

September 29, 2014

Part of what seems to motivate investors is a desire to make money in the context of working towards their financial goals.  However, part of the motivation for many investors is the accolades that come when they get a call right.  Think about all the bragging rights when you call a stock out as overvalued!  ”Yea, I shorted XYZ stock all the way down.  The numbers just didn’t make sense to me.”  If you can pull that off a couple times, CNBC will be booking you ASAP.  However, does it really make sense to try to short “overvalued” stocks—either from a financial perspective or from an accolades perspective?

Alon Bochman, CFA, of the CFA Institute has some data that should make you think twice.

Valuation shorts have a bad reputation on Wall Street. You may be right in the long run, but you may not be able to hold the position long enough to get there. As David Einhorn puts it, “We have repeatedly noted that it is dangerous to short stocks that have disconnected from traditional valuation methods. After all, twice a silly price is not twice as silly; it’s still just silly.

Valuation shorts are a dicey proposition on intellectual grounds, too. John Hempton, who is the chief investment officer at Bronte Capital and publishes one of my favorite investment blogs, puts it this way: “In a valuation short we are working on the same information as everyone else has. This makes me uncomfortable. There is an arrogance in suggesting we can analyze the information better than anyone else. We find it harder to answer the question of what we see when others don’t and hence harder to justify the position at all.”

I was curious whether valuation shorts work as a whole, and have recently had occasion to test this question using a new research service called Activist Shorts Research. They have compiled data on more than 400 campaigns by noted short-sellers from 2002 to the present. The returns look like this:

alon1 500x445 Do You Feel Lucky?

The mean price change (not including dividends), indicated by the blue line, was −14.2% over an entire “campaign,” which can be arbitrarily long. Additionally, 65% of campaigns were “successful” in the sense that the price of the target stock dropped since the campaign was announced. In 4% of campaigns, the price dropped 99% or more. These figures sound quite good, but it is important to note the sample is biased because the service does not cover all short-sellers, only the “best” and “most public” ones. These two groups likely overlap but not completely.

Despite the biases of the overall sample, the question I was most interested in was whether valuation shorts work better than fraud shorts. For each campaign in the dataset, we have a “Primary Allegation” which is the reason the short-seller used to publicly justify the short call. The reasons provided are many and varied, but I have grouped them into the two buckets we are interested in. The results are stark:

Primary Allegation Fraud Valuation Total
Mean Return −30% 3% −14%
Campaigns 229 219 448

Short campaigns that allege a stock is overvalued are wrong as a group: the target stock rises 3% over the life of the campaign, on average. Shorts that allege fraud are much more effective: the target stock drops 30% on average. We can see this result in some more detail by comparing return distributions:

My emphasis added.  On average, shorting stocks based on valuation hasn’t worked out so well.  You might win, but the odds aren’t in your favor.  Kind of like Vegas.

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Quote of the Week

September 19, 2014

People want to believe the present is different than the past. Markets are now computerized, high-frequency and block traders dominate, the individual investor is gone and in his place sit a plethora of huge mutual and hedge funds to which he has given his money. Some people think these masters of money make decisions differently, and believe that looking at how a strategy performed in the 1950s or 1960s offers little insight into how it will perform in the future.

But while we humans passionately believe that our own current circumstances are somehow unique, not much has really changed since the inarguably brilliant Isaac Newton lost a fortune in the South Sea Trading Company bubble of 1720.  Newton lamented that he could “calculate the motions of heavenly bodies but not the madness of men.”  Herein lays the key to why basing investment decisions on long-term results is vital: the price of a stock is still determined by people.

  –Jim O’Shaughnessey

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PFI Point & Figure Chart: Are Financial Stocks Poised For Rotation?

September 19, 2014

Global equity markets continue to grind higher during 2014, with the S&P 500 notching a new all -time closing high yesterday at 2,011.  However, not all groups of stocks have performed well during the course of the year, with certain sectors outperforming others.  Furthermore, large caps and mid -caps have outperformed small caps.   The ability for investors to gain exposure to the strongest performing sectors of the equity market is something our relative strength models at Dorsey Wright attempt to capture on a daily basis.  We are not looking to catch the very initial leg or final leg of a trend, but more importantly the “middle” portion of the trend where the majority of the gains are found.  Having a solid game plan intact to take advantage when these moves occur is essential in helping achieve consistent returns.

PowerShares DWA Financial Momentum Portfolio  (PFI)

At Dorsey Wright, we have a number of products that allow investors to take advantage of secular market rotation.   We do so in a systematic way which allows us to eliminate human emotion and not take proper action until our relative strength rankings give confirmation.

In this piece, we want to focus on the point and figure chart of the PowerShares DWA Financial Momentum Portfolio (PFI).   The PFI Index is derived by analyzing a matrix of stocks and finding the top 30-75 financial stocks in terms of relative strength.   The reason for discussion about PFI today is a notable technical development on the point and figure chart.

Point & Figure – Technical Developments on PFI:

Range bound markets are often difficult for momentum strategies because of the whipsaw like action which can occur at the top and bottom ends of the range.   Of course, periods of price congestion during an uptrend often lead to a sub-par relative strength ranking until the market can take out the overhead supply and confirm a new buy signal.  The discipline to avoid these markets (until a proper signal is given) in search of stronger trends is something our model-based approach is designed to help do.

A quick glance at the chart below shows the sideways consolidation that PFI is in.   Consolidations in steady trends are usually considered healthy as supply and demand will tend to battle it out over a period of time before one side eventually wins and the next major leg up (or down) commences.  The PFI point and figure currently remains on a sell signal, and a buy signal will not be given till a move through 30 occurs.   The longer PFI continues to consolidate, the more likely the move out of this pattern will be substantial which will likely contribute to stronger RS ratings for the product.

PFIUPDATED 300x240 PFI Point & Figure Chart:  Are Financial Stocks Poised For Rotation?


The above article gives a good example of why rules-based systematic approach to the markets can be so beneficial when investing.   As we stated above, financials as a group have struggled this year, underperforming the general market while other sectors have outperformed.  However, although the current relative strength ranking remains somewhere in the middle of the pack, the overall technical structure is worth keeping an eye on as price once again approaches the upper end of the range near $30.00.   The potential measured move target would be 34.50.

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

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

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

Dorsey Wright is the index provider for PFI.  See www.powershares.com for more information.

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Parsing the Narrative

September 10, 2014

There are changes afoot in the Fast Food industry.  From USA Today:

Fast-food’s old guard is giving way to a savvy new guard that is slowing-down the process and giving a needed nod to healthier ingredients…

…”Today’s 22-year-olds don’t frequent fast-food like the generation before them,” says Robin B. DiPietro, professor of hospitality at University of South Carolina. “Fast food will have to morph into something fresher and healthier.”

Among the companies that the article suggests are the future of Fast Food: Chipotle (CMG), Panera (PNRA), and Starbucks (SBUX).

Among the companies that are labeled the has-beens: Burger King (BKW), McDonald’s (MCD), Wendy’s (WEN), and KFC (owned by YUM).

Do the technicals match the narrative?  Generally, yes.  But, not in every case.  Dorsey Wright assigns a technical attribute score to every stock, which is derived from the relative strength and the trend of the stock.  The attributes range from 0-5, with 5 being the strongest.

Fast Food of the future (per article):

new Parsing the Narrative

Fast Food of the past (per article):

old Parsing the Narrative

A technical screen allows us to employ a variation of the old adage “Trust but verify.” The story line makes sense. Some of my own experiences tend to support the narrative that there are indeed major changes taking place in Fast Food, but there are clearly exceptions to the rule.  The stocks of some of the old guard are doing just fine, while the stocks of some of those thought to be the future are in fact lagging.

As with all narratives, best to let the technicals filter through the ideas to identify those that are being validated in the marketplace.  Change is a constant and relative strength is well-suited to objectively identify when those changes take place.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A list of all holdings for the trailing 12 months is available upon request.  Past performance is no guarantee of future returns.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Point and Figure RS Signal Implementation

September 2, 2014

Over the course of the summer we published three different whitepapers looking at point and figure relative strength signals on a universe of domestic equities.  In the first two papers, we demonstrated the power of using PnF RS signals and columns to find high momentum stocks, and then we looked at the optimal box size for calculating relative strength.  If you were on vacation and happened to miss one of the first two papers they can be found here and here.

The third paper examines the performance profiles you can reasonably expect by following a process designed around point and figure relative strength.  You can download a pdf version of the paper here.  Most momentum research focuses on performance based on purchasing large baskets of stocks, which is impractical for non-institutional investors.  Once we know that the entire basket of securities outperforms over time the next logical question is, “What happens if I just invest in a subset of the most highly ranked momentum securities?”  To answer this question, we created portfolios of randomly drawn securities and ran the process through time.  Each portfolio held 50 stocks at all times, which we believe is a realistic number for retail investors.  Each month we sold any security in the portfolio that was not one of the top relative strength ranks.  For every security that was sold, we purchased a new security at random from the high relative strength group that wasn’t already held in the portfolio.  We ran this process 100 times to create 100 different portfolio return streams that were all different.  The one thing all 100 portfolios had in common was they were always 100% invested in 50 stocks from the high relative strength group.  But the exact 50 stocks could be totally different from portfolio to portfolio.

The graph below taken from the paper shows the range of outcomes from our trials.  From year to year you never know if your portfolio is going to outperform, but over the length of the entire test period all 100 trials outperformed the broad market benchmark.

Random zps69d808c9 Point and Figure RS Signal Implementation

 (Click To Enlarge)

We believe this speaks to the robust nature of the momentum factor, and also demonstrates the breadth of the returns available in the highest ranked names.  It wasn’t just a small handful of names that drove the returns.  As long as you stick to the process of selling the underperforming securities and replacing them with stocks having better momentum ranks there is a high probability of outperformance over time.  Over short time horizons the outperformance can appear random, and two people following the same process can wind up with very different returns.  But over long time horizons the process works very well.

Past performance is not indicative of future results.  Potential for profits is accompanied by possibility of loss.  A momentum strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value. 

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Quote of the Week

August 6, 2014

Via Michael Covel, an excerpt from James O’Shaughnessy’s book What Works on Wall Street:

Models beat the human forecasters because they reliably and consistently apply the same criteria time after time. In almost every instance, it is the total reliability of application of the model that accounts for its superior performance. Models never vary. They are always consistent. They are never moody, never fight with their spouse, are never hung over from a night on the town, and never get bored. They don’t favor vivid, interesting stories over reams of statistical data. They never take anything personally. They don’t have egos. They’re not out to prove anything. If they were people, they’d be the death of any party.

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A Wise Old Owl

July 29, 2014

The essence of relative strength:

A wise old owl lived in an oak.  The more he saw the less he spoke.  The less he spoke the more he heard.  Why can’t we all be like that wise old bird?

HT: Patrick O’Shaughnessy

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Reality Check for Forecasting

July 28, 2014

I’d say this is a pretty compelling argument for trend following.  As shown below, the average strategist forecast for the S&P 500 is routinely way off.

forecasts Reality Check for Forecasting

Source: WSJ

Rather than even attempt to forecast the unknowable, trend followers simply stay with the trend, until it is time to move on.  See here, here, and here.

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Unrealistic Paradigms

July 21, 2014

The NYT unintentionally gives a great example of how NOT to analyze active equity strategies:

A new study by S.&P. Dow Jones Indices has some fresh and startling answers. The study, “Does Past Performance Matter? The Persistence Scorecard,” provides new arguments for investing in passively managed index funds — those that merely try to match market returns, not beat them.

Yet it won’t end the debate over active versus passive investing, because it also shows that a small number of active investors do manage to turn in remarkably good streaks for fairly long periods.

The study examined mutual fund performance in recent years. It found that very few funds have been consistently outstanding performers, and it corroborated the adage that past performance doesn’t guarantee future returns.

The S.&P. Dow Jones team looked at 2,862 mutual funds that had been operating for at least 12 months as of March 2010. Those funds were all broad, actively managed domestic stock funds. (The study excluded narrowly focused sector funds and leveraged funds that, essentially, used borrowed money to magnify their returns.)

The team selected the 25 percent of funds with the best performance over the 12 months through March 2010. Then the analysts asked how many of those funds — those in the top quarter for the original 12-month period — actually remained in the top quarter for the four succeeding 12-month periods through March 2014.

The answer was a vanishingly small number: Just 0.07 percent of the initial 2,862 funds managed to achieve top-quartile performance for those five successive years. If you do the math, that works out to just two funds. Put another way, 99.93 percent, or 2,860 of the 2,862 funds, failed the test.

Yes, that is right.  Unless a fund was in the top quartile of performance for each of the four years it was considered a failure.  The premise of the article is that investors should employ index funds unless they can find active strategies that outperform every year.  Talk about setting yourself up for failure!  I am aware of a number of investment factors that have generated outperformance over time (momentum, value, low volatility), but I am aware of nothing that outperforms every year.

The returns of those managers who are able to generate outperformance over time is rather lumpy.  Consider the performance profile of the best performing managers of the 1990′s as an example:

Cambridge Associates, a money management consulting firm, did a study of the top-performing managers for the decade of the 1990s. In 2000, they could look back and see which managers had returns in the top quartile for the entire decade. Presumably, these top quartile managers are precisely the ones that clients would like to identify and hire. Cambridge found that 98% of those top managers had periods of underperformance extending three years or more. 98% is not a misprint!  Even more striking, 68% of the top managers ended up in the bottom quartile for some three-year period and a full 40% of them visited the bottom decile during that ten years. Clearly, there are good and bad periods for every strategy.

Investing is challenging enough without setting yourself up for failure by placing unrealistic expectations on active managers.  I have nothing against index funds.  We use them in a number of our strategies and I think many investors can benefit from using them as part of their allocation.  However, they are not a panacea.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Cullen Roche on Michael Covel’s Podcast

July 18, 2014

Listen to the 12:45 – 15:20 mark in this interview.  Cullen Roche has some key comments on pragmatism (something that we discuss regularly at DWA and a concept that separates winning investors from the rest).

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Why Bother With Active?

July 14, 2014

National Geographic makes a provocative claim about longevity on one of its recent covers:

national geographic may 13 600x375 Why Bother With Active?

Our genes harbor many secrets to a long and healthy life.  And now scientists are beginning to uncover them.

While it might be a stretch that life expectancy in the US will be approaching 120 any time soon, what is not a stretch is that life expectancy continues to increase.  Among many other aspects of increased longevity, the financial implications of being a good investor are becoming more pronounced.

To illustrate, consider a simple example.  Suppose that when the baby on the cover of the magazine graduates from high school at age 18 he decides to take a summer job selling alarm systems door-to-door.  This boy is a very good salesman, and is able to pull in $100,000 before he heads off to college.  He decides to take that sum of money and invest it in the stock market.  Suppose that this boy ends up never needing to use that money and so throughout his very long life that money just stays invested and is able to earn 9 percent a year.  Compare that return to a different person who, over the same time frame, invests $100,000 and earns only 6 percent a year.

Table 1 Why Bother With Active?

With this simple example, it becomes easy to see how greater longevity can have an outsized reward for those investors who are able to generate even a couple percent excess return over time.  After only 10 years of investment results, the investor earning 9 percent a year only has 1.3 times more money than the investor earning 6 percent.  However, after 100 years there is an enormous difference of 16.3 more money.

Something to think about next time you hear someone say that it is not worth it to try to find an active strategy that is able to generate a couple percent in annual excess return over time.

This example is presented for illustrative purposes only and does not represent a past recommendation.  A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.

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Michael Covel Interviews Tom Dorsey

March 31, 2014

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

Tommy Pic 06small Michael Covel Interviews Tom Dorsey

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Packaged Discipline

March 21, 2014

With approaches to investing such as is described in the following excerpt from a post on Musing On Markets blog (written by a professor at NYU), is it any wonder that factor-based investing (aka “Smart Beta”) is taking off?

Assume that you value a stock at $20 and it is trading at $30. What would you do? If you are a value-based investor, the answer is easy, right? Don’t buy the stock, or perhaps, sell it short! Now let’s say it is three months later. You value the same stock again at $20 but it is now trading at $50. What would you do now? Rationally, the choice is simple, but psychologically, your decision just got more difficult for two reasons. The first stems from second guessing. Even if you believe that markets are not always rational, you worry that the market knows something that you don’t. The second is envy. Watching other people make money, even if their methods are haphazard and their reasoning suspect, is difficult. You are being tested as an investor, and there are three paths that you can take.

  1. Keep the faith that your estimate of value is correct, that the market is wrong and that the market will correct its mistakes within your time horizon. That may be what every value investing bible suggests, but your righteousness comes with no guarantees of profits.
  2. Abandon your belief in value and play the pricing game openly, either because your faith was never strong in the first place or because you are being judged (by your bosses, clients and peers) on your success as a trader, not an investor.
  3. Preserve the value illusion and look for “intrinsic” ways to justify the price, using one of at least three methods. The first is to tweak your value metrics, until you get the answer you want. Thus, if the stock looks expensive, based on PE ratios, you try EV/EBITDA multiples and if it still looks expensive, you move on to revenue multiples. As I argued in my post on the pricing of social media companies, you will eventually find a metric that will make your stock look cheap. The second is to claim to do a discounted cash flow valuation, paying no heed to internal consistency or valuation first principles, making it a DCF more in name than in spirit. The third is to use buzzwords, with sufficient power to explain away the difference between the price and the value.

The level of subjective decision-making described above is a recipe for ulcers, unhappy clients, and likely a short career in this industry.  Such an investor follows a different discipline (I use that term loosely in this context) every day.  Every change in investment philosophy is largely based on changes in feelings.

One of the major reasons why there has never been a better time to be an advisor in this industry than today is because of the ability to access disciplined investment strategies (aka “Smart Beta”) in rules-based indexes where the risk of the manager not following the discipline is largely removed.  Books, such as What Works on Wall Street by Jim O’Shaughnessy, clearly point out that there are a number of return factors that have been able to generate excess return over time.  In my opinion, one of the biggest reasons that “actively managed strategies” have had such a poor track record, in aggregate, over time is because the investment committee of these strategies sits around and goes through some variation of steps 1-3 shown above on a regular basis.  In other words, there is no discipline! 

Consider the following exchange between Tom Dorsey and IndexUniverse from last year on the topic of the future of the ETF industry.  Tom was asked to explain his statement that the future of the ETF market is “ETF Alchemy.”

Dorsey: Think about this for a second: If I take H2 and I add O, what do I get?


Dorsey: Yes, water. Each one of those two elements is separate. But when I combine the two, I come up with a substance—water—that you can’t live without. Each one separately is not as good as the two combined. And the concept here is, What’s out there in terms of ETFs I can combine together to make a better product?

Take for instance the Standard & Poor’s Low Volatility Index—and if you add that to PDP, which is our Technical Leaders Index, and combine the two, it’s like taking two glasses of water and pouring them into one bigger glass of water, 50-50. I end up with a better product than either one of them separately.

You’ll find this as we go along: the ability to combine different ETFs to create a better unit where the whole is better than the sum of its parts.

A little later in the interview, Tom Dorsey spoke to just how important the ETF has been to the industry:

Dorsey: Yes, and I can’t tell you how many seminars I have taught to professionals on ETFs and the eyes that widen and the lives that change once they understand it and understand how to use it; it tells me we’re on the right path and this is the exact right product.

Like I’ve said to you before, it’s probably the most important product ever created in my 39 years in this business. And I believe back then when I talked to you that we’re in the first foot of a 26-mile marathon.

With some reasonable amount of due diligence, advisors today can identify a handful of investment factors that have historically provided excess return.  The advisor can then combine these strategies—now plentifully available in ETF format—for a client in a way that provides diversified and disciplined exposure to winning return factors at a reasonable cost.

Dorsey Wright is the index provider for PDP.  For more information, please see www.powershares.com.  A momentum strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value.  Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss.  

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Picking the Winners: NCAA Office Pool Edition

March 18, 2014

The WSJ this morning on how to win your NCAA Office Pool:

Pick the favorites. This is the only foolproof way to guarantee you won’t embarrass yourself.

For all of the attention paid to underdogs—is there any other reason you know Florida Gulf Coast University exists?—the better team still wins most round-of-64 games. Over the last 10 seasons, the average number of double-digit seeds beating favorites was six per tournament. Meanwhile, a bracket with favorites winning every game last year would have placed in the 91st percentile of entries to ESPN’s contest, a company spokeswoman said. In other words, your bracket can only be so contrary until it’s cuckoo.

Part of the fun of NCAA Office Pools is bragging rights of picking the underdogs (even if it’s a statistical unlikelihood).  However, this same principle applies to investing.  When it comes to the financial markets, rather than shoot for bragging rights, go for the money!

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Time and Discipline

March 16, 2014

I love this image from Carl Richards of Behavior Gap:

Time and discipline Time and Discipline

Experience teaches us that the image above is true.  Anyone can get it right in the short run.  We’ve all seen it.  The gambler at the slot machines who walks out with a few thousand dollars, the sports fan who successfully bets on his home team over the higher ranked opponent, the investor who makes some money buying stock in a company recommended by his brother-in-law.  Yet, will any of the previous approaches end well in the long run?  Not likely.

Relative strength happens to be our discipline of choice.  It has been extensively tested.  It is logical.  It has been effective over time.  There are other disciplines that have also been effective over time.  There are many approaches that fall in the category of undisciplined.  One example: the quant manager who incorporates many different return factors into an ever-changing investment model.  A tweak here.  A tweak there…

When building allocations meant to last and designed to make a meaningful difference for a client over time, advisors and their clients would be well served to build allocations around effective disciplines and leave the rest by the wayside.

A relative strength strategy is NOT a guarantee.  There may be times where all investments and strategies are unfavorable and depreciate in value. Past performance is no guarantee of future returns. Potential for profits is accompanied by possibility of loss. 

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Survivorship Bias

February 28, 2014

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

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

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

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


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

Source: Alvarez Quant Trading

(click on image to enlarge to full size)

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

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

Mr. Alvarez concludes:

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

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

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How Not to be a Terrible Investor

February 27, 2014

Morgan Housel at Motley Fool has a wonderful article on how investors can learn from failure.  He sets the tone with a few different quotes and anecdotes that point out that a lot of being a success is just avoiding really dumb mistakes.

At a conference years ago, a young teen asked Charlie Munger how to succeed in life. “Don’t do cocaine, don’t race trains to the track, and avoid all AIDS situations,” Munger said. Which is to say: Success is less about making great decisions and more about avoiding really bad ones.

People focus on role models; it is more effective to find antimodels—people you don’t want to resemble when you grow up.    Nassim Taleb

I’ve added the emphasis, but Mr. Housel makes a good point.  Learning from failure is equally important as learning from success.  In fact, he argues it may be more important.

If it were up to me, I would replace every book called How to Invest Like Warren Buffett with a one called How to Not Invest Like Lehman Brothers, Long-Term Capital Management, and Jesse Livermore. There are so many lessons to learn from these failed investors about situations most of us will face, like how quickly debt can ruin you. I’m a fan of learning from Buffett, but the truth is most of us can’t devote as much time to investing as he can. The biggest risk you face as an investor isn’t that you’ll fail to be Warren Buffett; it’s that you’ll end up as Lehman Brothers.

But there’s no rule that says you have to learn by failing yourself. It is far better to learn vicariously from other people’s mistakes than suffer through them on your own.

That’s his thesis in a nutshell.  He offers three tidbits from his study of investing failures.  I’ve quoted him in full here because I think his context is important (and the writing is really good).

1. The overwhelming majority of financial problems are caused by debt, impatience, and insecurity. People want to fit in and impress other people, and they want it right now. So they borrow money to live a lifestyle they can’t afford. Then they hit the inevitable speed bump, and they find themselves over their heads and out of control. That simple story sums up most financial problems in the world. Stop trying to impress people who don’t care about you anyways, spend less than you earn, and invest the rest for the long run. You’ll beat 99% of people financially.

2. Complexity kills. You can make a lot of money in finance, so the industry attracted some really brilliant people. Those brilliant people naturally tried to make finance more like their native fields of physics, math, and engineering, so finance has grown exponentially more complex in the last two decades. For most, that’s been a disservice. I think the evidence is overwhelming that simple investments like index funds and common stocks will demolish complicated ones like derivatives and leveraged ETFs. There are two big stories in the news this morning: One is about how the University of California system is losing more than $100 million on a complicated interest rate swap trade. The other is about how Warren Buffett quintupled his money buying a farm in Nebraska. Simple investments usually win.

3. So does panic. In his book Deep Survival, Laurence Gonzalez chronicles how some people managed to survive plane crashes, getting stranded on boats, and being stuck in blizzards while their peers perished. The common denominator is simple: The survivors didn’t panic. It’s the same in investing. I’ve seen people make a lifetime of good financial decisions only to blow it all during a market panic like we saw in 2008. Any financial decision you make with an elevated heart rate is probably going to be one you’ll regret. Napoleon’s definition of a military genius was “the man who can do the average thing when all those around him are going crazy.” It’s the same in investing.

I think these are really good points.  It’s true that uncontrolled leverage accompanies most real blowups.  Having patience in the investing process is indeed necessary; we’ve written about that a lot here too.  The panic, impatience, and insecurity he references are really all behavioral issues—and it just points out that having your head on straight is incredibly important to investment success.  How successful you are in your profession or how much higher math you know is immaterial.  As Adam Smith (George Goodman) wrote, “If you don’t know who you are, the stock market is an expensive place to find out.” 

Mr. Housel’s point on complexity could be a book in itself.  Successful investing just entails owning productive assets—the equity and debt of successful enterprises—acquired at a reasonable price.  Whether you own the equity directly, like Warren Buffett and his farm, or in security form is immaterial.  An enterprise can be a company—or even a country—but it’s got to be successful.

Complexity doesn’t help with this evaluation.  In fact, complexity often obscures the whole point of the exercise.

This is actually one place where I think relative strength can be very helpful in the investment process.  Relative strength is incredibly simple and relative strength is a pretty good signaling mechanism for what is successful.  Importantly, it’s also adaptive: when something is no longer successful, relative strength can signal that too.  Sears was once the king of retailing.  Upstart princes like K-Mart in its day, and Wal-Mart and Costco later, put an end to its dominance.  Once, homes were lit with candles and heated with fuel oil.  Now, electricity is much more common—but tomorrow it may be something different.  No asset is forever, not even Warren Buffett’s farmland.  When the soil is depleted, that farm will become a lead anchor too.  Systematic application of relative strength, whether it’s being used within an asset class or across asset classes, can be a very useful tool to assess long-term success of an enterprise.

Most investing problems boil down to behavioral issues.  Impatience and panic are a couple of the most costly.  Avoiding complexity is a different dimension that Mr. Housel brings up, and one that I think should be included in the discussion.  There are plenty of millionaires that have been created through owning businesses, securities, or real estate.  I can’t think of many interest rate swap millionaires (unless you count the people selling them).  Staying calm and keeping things simple might be the way to go.  And if the positive prescription doesn’t do it for you, the best way to be a good investor may be to avoid being a terrible investor!

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The Growing Case Against ETFs

February 21, 2014

That’s the title of a Marketwatch article by mutual fund columnist Chuck Jaffe.  I have to admit that usually I like his columns.  But columns like this make me nuts!  (See also The $ Value of Patience for an earlier rant on a similar topic.)

Here’s the thesis in a nutshell:

…safe driving comes down to a mix of equipment and personnel.

The same can be said for mutual funds and exchange-traded funds, and while there is growing consensus that ETFs are the better vehicle, there’s growing evidence that the people using them may not be so skilled behind the wheel.

The article goes on to point out that newsletters with model portfolios of mutual funds and ETFs have disparate results.

Over the last 12 months, the average model portfolio of traditional funds—as tracked by Hulbert Financial Digest—was up 20.9%, a full three points better than the average ETF portfolio put together by the same advisers and newsletter editors. The discrepancy narrows to two full percentage points over the last decade, and Hulbert noted he was only looking at advisers who run portfolios on both sides of the aisle.

Hulbert posited that if you give one manager both vehicles, the advantages of the better structure should show up in performance.

It didn’t.

Hulbert—who noted that the performance differences are “persistent” — speculated “that ETFs’ advantages are encouraging counterproductive behavior.” Effectively, he bought into Bogle’s argument and suggested that if you give an investor a trading vehicle, they will trade it more often.

Does it make any sense to blame the vehicle for the poor driving?  (Not to mention that DALBAR data make it abundantly clear that mutual fund drivers frequently put themselves in the ditch.)  Would it make sense to run a headline like “The Growing Case Against Stocks” because stocks can be traded?

Mutual funds, ETFs, and other investment products exist to fulfill specific needs.  Obviously not every product is right for every investor, but there are thousands of good products that will help investors meet their goals.  When that doesn’t happen, it’s usually investor behavior that’s to blame.  (And you’re not under any obligation to invest in a particular product.  If you don’t understand it, or you get the sinking feeling that your advisor doesn’t either, you should probably run the other way.)

Investors engage in counterproductive behavior all the time, period.  It’s not a matter of encouraging it or not.  It happens in every investment vehicle and the problem is almost always the driver.  In fact, advisors that can help manage counterproductive investor behavior are worth their weight in gold.   We’re not going to solve problems involving investor behavior by blaming the product.

A certain amount of common sense has to be applied to investing, just like it does in any other sphere of life.  I know that people try to sue McDonald’s for “making” them fat or put a cup of coffee between their legs and then sue the drive-thru that served it when they get burned, but whose responsibility is that really?  We all know the answer to that.

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