When testing a model it is always difficult to determine if the results you are achieving are repeatable or not.  If you are testing a high relative strength model, for example, are the results coming from one or two stocks that make the whole test look fantastic?  If that is the case I would have my doubts about how that strategy would perform in real-time.  But if the results are truly from an underlying factor performance (regardless of the individual securities in the portfolio) then you have something you can work with.

The way we determine if a model is lucky or not is to run multiple simulations based on a random draw of securities.  In a relative strength model we might break our universe into ten different buckets.  Out of the highest bucket we might draw 50 stocks at random.  We hold those stocks until they are no longer classified as high relative strength securities.  Once they fall below a specific rank we sell the security and buy another one at random.  If we run 100 trials we get 100 different portfolios over time.  What we are trying to determine is if the individual securities in the test really matter, or is just the concept of buying high relative strength securities over time what causes the outperformance.

As it turns out, what stocks go in to the portfolio aren’t as important as exploiting the factor.  A disciplined approach is that consistently drives the portfolio to strength is what drives the returns over time.

(Click To Enlarge)

The table shows the results from one of the factors tested in the paper.  You can see the range of outcomes each year as well as how each model did over the 16 year test period.  Sometimes the models outperform, sometimes the underperform, and some years you have mixed results.  But over 16 years, all of the models outperformed!  All we did was pick stocks at random out of a high relative strength basket.  There is nothing complicated about it.  The main thing is that the process is systematic and extremely disciplined.

More details about the testing process and results can be found in the paper (click here).

If you let the financial services industry do exactly what it wants, the financial services industry will eventually get itself — and by extension the economy — into staggering amounts of trouble. If you force it to behave, it might just thrive.

I don’t think you can ever force anyone to behave.  I was never successful forcing my kids to behave when they were four years old, and I have no more success now that they are teenagers.  This thesis leads to some bad logic.  Mr. Fox continues:

I thought about this while listening Tuesday to David Swensen, the legendary manager of Yale University’s endowment, arguing that acting as a fiduciary for other people’s money and maximizing profits are incompatible activities. “A fiduciary would offer low-volatility funds and encourage investors to stay the course,” he said. “But the for-profit mutual fund industry benefits by offering high-volatility funds.”

Swensen said this at a Bloomberg Link conference held in honor of that great fiduciary, Vanguard founder Jack Bogle.

I have a few issues with this.  First, the data argues that low-volatility funds are not the answer.  If low volatility were the answer, customers would hold their low-volatility bond funds longer than they hold their high-volatility stock funds—but they don’t.  Holding periods, according to DALBAR data, are only marginally different, around three years in each case, so that argument goes up in flames.  Second, investment firms always encourage investors to stay the course, sometimes to a fault.  (And they usually end up getting criticized for it later by some Congressional panel with 20/20 hindsight.)  Seriously, did you ever read material produced by any reputable investment firm suggesting day-trading or short-term speculation?

Mr. Fox extols Jack Bogle and Vanguard for being great guardians of the investor, yet Vanguard is one of the biggest players in exchange-traded funds, something Mr. Bogle has decried as a terrible product that encourages speculation!  Does that make Vanguard evil?  (I don’t agree with that either.  ETFs don’t kill people; investors shoot themselves.)  Reality is a lot messier than an idealogical paradigm.

It all boils down to incentives.  Human beings are not all that tractable.  It’s certainly not easy to get investors to behave rationally either, and it’s not for lack of pleading by the investment companies.  Believe me, every firm would rather you keep your account there permanently!  But rather than “forcing” someone to behave, why not give them incentives to behave?

An anecdote might illustrate my point.  I worked many years ago at Smith Barney, Harris Upham when it was still private.  Share ownership was widely distributed and many people—partners and aspiring partners—felt like they had a stake in how things worked.  It was viewed in the industry as a stodgy firm that was not willing to take big risks, which was pretty much true.  The partners didn’t want to take big risks with the firm’s money because the firm’s money was their money!  Eventually the partners sold out to a public company.  The first convertible bond underwriting client that was engaged after the firm became public went bankrupt before it made its first semi-annual interest payment.  I can’t prove it, but I suspect that the partners weren’t as concerned about the underlying credit quality of the issuer when it wasn’t their money at stake anymore.  (In an interview, John Gutfreund of the old Salomon Brothers said using other people’s money was the beginning of the end.)  How many toxic mortgages would have been securitized if the partners’ personal money were at stake, or if even public firms had been required to retain substantial amounts of each pool?  Surely much less monkey business would have gone on.  (Stupidity you can’t regulate.  But if someone knows they have a grenade, they’re not happy about playing catch with it.)  Intelligent structuring of incentives will solve many of the problems that Mr. Fox rightly points out.

And, one could argue that incentives are already having an effect.  Mr. Fox mentions in passing some good actors in the industry (and I’m sure there are others):

Some of these for-profit advisers (Capital Group and T. Rowe Price spring to mind) have built a reputation for looking out for investors’s interests.

And guess what?  These firms are now huge because they realized they would have the best chance at sustainable, long-term growth by looking out for investors.  Enlightened consideration of their incentives led them to behave in ways that maximized their long-term growth.  There are other firms in the industry that have marketed celebrity portfolio managers, or have pushed performance when they were hot, or have launched all manner of ill-conceived products, but they have generally come to grief in the longer run.  (Short-termism, by the way, is not limited to for-profit enterprises.)

Could the industry incentivize even better behavior?  Possibly, and that is certainly a goal worth pursuing.  But to lay the blame for industry problems on the profit motive is just lazy thinking, in my opinion.

HT to Abnormal Returns

In the early 1980s, Philip Tetlock at UC Berkeley picked two hundred and eighty-four people who made their living “commenting or offering advice on political and economic trends” and began asking them to make predictions about future events. He had a long list of pertinent questions. Would George Bush be re-elected? Would there be a peaceful end to apartheid in South Africa? Would Quebec secede from Canada? Would the dot-com bubble burst? In each case, the pundits were asked to rate the probability of several possible outcomes. Tetlock then interrogated the pundits about their thought process, so that he could better understand how they made up their minds. By the end of the study, Tetlock had quantified 82,361 different predictions.

After Tetlock tallied up the data, the predictive failures of the pundits became obvious. Although they were paid for their keen insights into world affairs, they tended to perform worse than random chance. Most of Tetlock’s questions had three possible answers; the pundits, on average, selected the right answer less than 33 percent of the time. In other words, a dart-throwing chimp would have beaten the vast majority of professionals. Tetlock also found that the most famous pundits in Tetlock’s study tended to be the least accurate, consistently churning out overblown and overconfident forecasts. Eminence was a handicap.

This is the very reason that we rely on systematic trend following. Experts may sound convincing, but don’t count on their predictions.

—-this article was originally published 11/17/2009.  Expert opinion is still worse than random chance.  Improve your odds with a systematic investment process.

The figures, from the National Association of College and University Business Officers and the Commonfund, show total returns for university endowments averaged about 19% during fiscal year 2011, which ended June 30…

I don’t know if the returns are calculated on a dollar-weighted or equal-weighted basis, but any way you cut it, that’s not a bad year for a broadly diversified account.

You may or may not be aware that Dorsey Wright Money Management acts as a sub-advisor for the Arrow DWA Balanced Fund, a fund that was designed with the endowment model in mind.  It has dedicated sleeves for domestic equities, international equities, fixed income, and alternative assets.  According to Morningstar, our returns were similar over the fiscal year, coming in at 20.9%.

The balanced fund is not designed to be a high-octane vehicle.  It aims for steady performance in a wide variety of market environments and might be just the thing for clients who are looking for a little less volatility, while still having a chance for capital growth.

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

Momentum works. Seminal research by Narasimhan Jegadeesh and Sheridan Titman in 1993 first identified momentum as a systematic source of risk for equity investors. Their research—corroborated by numerous subsequent academic studies—revealed that, historically, momentum investing had provided excess stock returns over a market index.

…..

Overall, momentum returns outperformed market returns by an average of 3.13 percentage points on an annualized basis.

You can see the results on a country-by-country basis below.

Source: Forbes/Gerstein Fisher

Leaving aside the ridiculous statement about momentum being first identified in 1993, their study is important because it shows that momentum returns are universal.  Based on their study and others, we agree.  Dorsey Wright has been running a Systematic RS International portfolio since 2006 and the results have been excellent.  Our net returns have exceeded the EAFE benchmark by a similar amount to what Gerstein Fisher found–not surprising given the substantial overlap in time frames.

To receive the brochure for our Separately Managed Accounts, click here.  

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

The fact that interest rates tell us the truth about ourselves is intolerable to the political class. They don’t want us to be told the truth. They want low interest rates to foster the illusion that inflation is low in order to create the perception that capital is abundant, and to enable their governments to borrow more than they should by subsidizing the interest rates through money creation; the latter necessary to muffle the alarm bells of rising default risk.

But if the interest rate is the basis on which all investments, or for that matter, all spending decisions are made, and the interest rates are being distorted by central banks, then that means that all valuation is plunged into chaos. That is exactly what is happening right now. Nobody knows how to value anything. (emphasis added)

Valuation models are vulnerable to paradigm shifts.  Interest rates are arguably being manipulated to a much greater degree than has been seen in the past.  Price, on the other hand, will always be the intersection of supply and demand.  Trend following models should do just fine in an era of highly manipulated interest rates and are likely to effectively capitalize on the resultant bubbles.

Although early in the year, taxable bond funds are well in the lead–having already attracted over $18 billion in net new money.