From 1994 through 2009, the buy-the-unloved strategy produced an annualized 8.1% return, compared with 4.77% for the loved, 6.24% for the S&P 500, 6.96% for the Wilshire 5000, and 5.36% for the MSCI World. This assumes you invest in the unloved categories for three years running and then roll over the oldest group into the new unloved group starting in year four. 

The strategy also produced strong results if you run it on a five-year rotation. In that version, the unloved produced an 8.08% annualized return, compared with 4.25% for the loved, 5.17% for the S&P 500, 5.76% for the Wilshire 5000, and 4.55% for the MSCI World.

While it is no shock that going opposite retail (and institutional pension funds!) investors is profitable, it may be a bigger surprise what the portfolio is buying this year.

Based on the 12-month flows through the end of January, the unloved categories to buy now are large-cap growth, large-cap value, and world stock.

Note: this would be a good time to point out that our Systematic RS Aggressive and Core portfolios fit solidly within the large-cap category!  I will be pleasantly surprised if we begin to see flows into our domestic equity products by far-seeing, patient advisors.  Industry practice is to wait until there is a good marketing window for retail investors–usually after a year or two of strong performance.  There’s nothing wrong with that, but since the timing isn’t optimal, investors have to be prepared to weather a couple of cycles to really get maximum benefit from the strategy.  If I were in advertising, I would advise you to beat the rush and buy domestic large cap stocks today!

States and companies have started investing very differently when it comes to the billions of dollars they are safeguarding for workers’ retirement.  Companies are quietly and gradually moving their pension funds out of stocks. They want to reduce their investment risk and are buying more long-term bonds.

Besides bonds, where else are they going?

Though they generally say that their strategies are aimed at diversification and are not riskier, public pension funds are trying a wide range of investments: commodity futures, junk bonds, foreign stocks, deeply discounted mortgage-backed securities and margin investing. And some states that previously shunned hedge funds are trying them now.

What type of return do they need?

A spokeswoman for the Texas teachers’ fund said plan administrators believed that such alternative investments were the likeliest way to earn 8 percent average annual returns over time.

Why pensions don’t want to lower their return assumptions:

A growing number of experts say that governments need to lower the assumptions they make about rates of return, to reflect today’s market conditions.  But plan officials say they cannot.  “Nobody wants to adjust the rate, because liabilities would explode,” said Trent May, chief investment officer of Wyoming’s state pension fund.

Why not increase contributions?

Colorado cannot afford the contributions it owes, even at the current estimated rate of return. It has fallen behind by several billion dollars on its yearly contributions, and after a bruising battle the legislature recently passed a bill reducing retirees’ cost-of-living adjustment, to 2 percent, from 3.5 percent. Public employees’ unions are threatening to sue to have the law repealed.

This is insanity!  It is time for public pension plans to face the music.  They need a better investment approach.  It’s after reading articles like this that I become even more grateful that we adhere to a dynamic approach to investing that doesn’t have any bias about where returns will come from in the future.  We simply allow relative strength to dictate how we will be allocated.  They have sworn off US equities because of their volatility and of their underperformance relative to other asset classes over the last ten years.  However, it is entirely possible that US equities could be the very best performing asset class over the next ten years.

They need to realize that nobody is entitled to 8% per year.  I think 8% a year, and even better, is very possible over time, but you have to earn it by adhering to an effective investment plan.  Furthermore, there is no way to get that year in and year out unless you are one of Bernie Madoff’s clients.

They need to quit promising guaranteed benefits that are completely out of line with reality.  Rather, they should pay out benefits that fluctuate according to how the pension performs.  That is how the rest of us live.

Finally, funding the pension cannot be optional.  It must be funded each year, regardless of the opposition.

There, I’m done.

The sharp decline in the RS Spread for much of the last 12 months has moderated considerably in recent months, and may well be setting the stage for a more favorable RS environment.

Trends are everywhere – weather, sports, fashion, food, entertainment, health, science and politics. Some trends are long, some are short. They come and they go as they always have and always will. Life and business both thrive on identifying, following and serving trends. Market prices for metals, currencies, energies or bonds are no different.

This is why we are never very concerned when markets are trendless for a while.  New trends come and go all the time, and our Systematic RS process is designed to identify the strongest trends and to latch on to them.  The trends that continue for a long period of time can be very profitable.

via www.MichaelCovel.com

Last week’s performance (3/1/10 – 3/5/10) is as follows:

That is my kind of week – great performance for the broad market and even better performance for high relative strength stocks!  Now, if I annualized that performance…

It turns out that the majority of the best days and the worst days occur near one another, during the declines.  Why?  Because the market is more volatile during declines.  It is true that the market goes down 2-3x as fast as it goes up.  (World Beta has a nice post on this topic of volatility clustering, which is where this handy-dandy table comes from.)

from World Beta

You can see how volatility increases and the number of days with daily moves greater than 2.5% really spikes when the market is in a downward trend.  It would seem to be a very straightforward proposition to improve your returns simply by avoiding the market when it is in a downtrend.

However, not every strategy can be improved by going to cash.  Think about the math: if your investing methodology makes enough extra money on the good days to offset the bad days, or if it can make money during a significant number of the declines, you might be better off just gritting your teeth during the declines and banking the higher returns.  Although the table above suggests it should help, a simple strategy of exiting the market (i.e., going to cash) when it is below its 200-day moving average may not always live up to its theoretical billing.

click to enlarge

Consider the graphs above.  (The first graph uses linear scaling; the second uses logarithmic scaling for the exact same data.)  This test uses Ken French’s database to get a long time horizon and shows the returns of two portfolios constructed with market cap above the NYSE median and in the top 1/3 for relative strength.  In other words, the two portfolios are composed of mid- and large-cap stocks with good relative strength.  The only difference between the two portfolios is that one (red line) goes to cash when it is below its 200-day moving average.  One portfolio (blue line) stays fully invested.  The fully invested portfolio turns $100 into $49,577, while the cash-raising portfolio yields only $26,550.

If you would rather forego the extra money in return for less volatility, go right ahead and make that choice.  But first stack up 93 boxes of  Diamond matches so that you can burn 23,027 $1 bills, one at a time, to represent the difference–and then make your decision.

The drawdowns are less with the 200-day moving average, but it’s not like they are tame–equities will be an inherently volatile asset class as long as human emotions are involved.  There are still a couple of drawdowns that are greater than 20%.  If an investor is willing to sit through that, they might as well go for the gusto.

As surprising as it may seem, the annualized return over a long period of time is significantly higher if you just stay in the market and bite the bullet during train wrecks–and even two severe bear markets in the last decade have not allowed the 200-day moving average timer to catch up.

At the bottom of every bear market, of course, it certainly feels like it would have been a good idea (in hindsight) to have used the 200-day moving average to get out.  In the long run, though, going to cash with a high-performing, high relative strength strategy might be counterproductive.  When we looked at 10-year rolling returns, the fully invested high relative strength model has maintained an edge in returns for the last 30 years running.

click to enlarge

Surprising, isn’t it?  Counterintuitive results like this are one of the reasons that we find testing so critical.  It’s  easy to fall in line with the accepted wisdom, but when it is actually put to the test, the accepted wisdom is often wrong.  (We often find that even when shown the test data, many people refuse, on principle, to believe it!  It is not in their worldview to accept that one of their cherished beliefs could be false.)  Every managed portfolio in our Systematic RS lineup has been subjected to heavy testing, both for returns and–and more importantly–for robustness.  We have a high degree of confidence that these portfolios will do exceedingly well in the long run.

Mr. Achuthan is also forecasting more frequent ups and downs in the economy going forward, so he concludes that buy-and-hold investing is dead.  We nominate him as a charter member of Economists For Tactical Allocation.

There is some cold comfort in knowing that no matter how tragic the world’s events may seem, the market is one thing we don’t need to worry about when sudden tragedy strikes.

No doubt, there are many investors who  dial back their risk or largely avoid risk altogether  (unwisely, it turns out) because of fear of unexpected shocks.