Dorsey Wright Managed Accounts

January 27, 2014


Our Systematic Relative Strength portfolios are available as managed accounts at a large and growing number of firms.

  • Wells Fargo Advisors (Global Macro available on the Masters/DMA Platforms)
  • Morgan Stanley (IMS Platform)
  • TD Ameritrade Institutional
  • UBS Financial Services (Aggressive and Core are available on the MAC Platform)
  • RBC Wealth Management (MAP Platform)
  • Raymond James (Outside Manager Platform)
  • Stifel Nicolaus
  • Kovack Securities
  • Deutsche Bank
  • Charles Schwab Institutional
  • Sterne Agee
  • Scott & Stringfellow
  • Envestnet
  • Placemark
  • Scottrade Institutional
  • Janney Montgomery Scott
  • Robert W. Baird
  • Wedbush Morgan
  • Prospera
  • Oppenheimer (Star Platform)
  • SunTrust
  • Lockwood

Different Portfolios for Different Objectives: Descriptions of our seven managed accounts strategies are shown below.  All managed accounts use relative strength as the primary investment selection factor.

Aggressive:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  It invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.

Core:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This strategy tends to have lower turnover and higher tax efficiency than our Aggressive strategy.

Growth:  This Mid and Large Cap U.S. equity strategy seeks to achieve long-term capital appreciation with some degree of risk mitigation.  This portfolio invests in securities that demonstrate powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  This portfolio also has an equity exposure overlay that, when activated, allows the account to hold up to 50% cash if necessary.

International: This All-Cap International equity strategy seeks to achieve long-term capital appreciation through a portfolio of international companies in both developed and emerging markets.  This portfolio invests in those securities with powerful relative strength characteristics and requires that the securities maintain strong relative strength in order to remain in the portfolio.  Exposure to international markets is achieved through American Depository Receipts (ADRs).

Global Macro: This global tactical asset allocation strategy seeks to achieve meaningful risk diversification and investment returns.  The strategy invests across multiple asset classes: Domestic Equities (long & inverse), International Equities (long & inverse), Fixed Income, Real Estate, Currencies, and Commodities.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).

Balanced: This strategy includes equities from our Core strategy (see above) and high-quality U.S. fixed income in approximately a 60% equity / 40% fixed income mix.  This strategy seeks to provide long-term capital appreciation and income with moderate volatility.

Tactical Fixed Income: This strategy seeks to provide current income and strong risk-adjusted fixed income returns.   The strategy invests across multiple sectors of the fixed income market:  U.S. government bonds, investment grade corporate bonds, high yield bonds, Treasury inflation protected securities (TIPS), convertible bonds, and international bonds.  Exposure to each of these areas is achieved through exchange-traded funds (ETFs).


To receive fact sheets for any of the strategies above, please e-mail Andy Hyer at or call 626-535-0630.  Past performance is no guarantee of future returns.  An investor should carefully review our brochure and consult with their financial advisor before making any investments.

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Emotional Investment and How to Escape It

August 16, 2012

Let’s face it; investors often make bad investment decisions. Commonly, this is due to our emotions getting in the way. BlackRock lists some of the emotional investment tendencies that often cloud our judgment and steer us toward poor decisions:

  • Anchoring: Holding onto a reference point, even if it’s irrelevant. For example, a $1.5 million house, being presented on its own, might sound expensive. But if you were first shown a $2 million house, and afterwards shown the $1.5 million house, it might then sound like a good deal.
  • Herding: Following the crowd. People often pile into the markets when they are doing well and they see “everyone else” doing it.
  • Mental Accounting: Separating money into buckets that are treated differently. Earmarking funds for college savings or a vacation home allows you to save for specific goals. But treating those dollars differently may not make sense when they all have the same buying power.
  • Framing: Making a different decision based on context. In a research study, when a four-ounce glass had 2 ounces of water poured out of it, 69% of people said it was now “half empty.” If the same glass starts out empty and has 2 ounces of water poured into it, 88% of people say it is “half full.”

Emotional investment tendencies can result in all sorts of problems.  Typically these behaviors are so ingrained that we don’t even recognize them as irrational!

One way to combat our emotions is to hire a good advisor. As explained in this previous blog post, one important benefit—maybe even the primary benefit—of having a good advisor is behavior modification. An advisor persuading a client to invest more when the market is doing poorly, instead taking money out, is extremely valuable.

Another option is to invest in a managed product like an ETF or mutual fund (here are some of ours) that will make the decisions for you. For an emotional investor, this may be an easier (and presumably safer) option than picking and obsessively monitoring a few random stocks. Even then, it is important try to avoid the herd mentality. Data shows that it’s most important to avoid panic at market bottoms.  Although it is difficult not to panic if other people around you are fearful, the potential difference in your investment return can be significant.

In short, understanding your emotional tendencies may help keep them from interfering in investment decisions. If that isn’t enough, try enlisting the help of an outside source. With the steady hand of a good advisor, it may be possible to mitigate emotional investment tendencies.

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A Case for American Investment

August 13, 2012

It’s fashionable to bash the US, what with a gridlocked Congress and the fiscal cliff, but if you’re looking to expand your portfolio, you might seriously consider investing domestically instead of overseas. U.S. companies have multiple benefits that you may not find elsewhere. Surprisingly, Politico recently outlined some of America’s investment advantages:

First, the U.S. has favorable demographics — thanks to its relatively high birth rates and immigration. While the BRIC countries —Brazil, Russia, India and China— have generated extraordinary economic growth, the U.S.remains a magnet for many of the smartest, most ambitious people in the world.

Second, the ability to better tap into domestic sources of energy — natural resource-based and, to a lesser but promising extent, the growing array of clean technologies — will spur more job-creating investments, improving our balance of payments.

Third, U.S. policymakers were aggressive in responding to the financial crisis, and the financial sector has been quick to increase capital and reduce leverage.

Fourth, U.S. companies have restructured more quickly and more extensively than others since 2008 — boosting U.S. productivity growth.

The United States is a logical place to invest, but it is not without its problems. Politico also lists ways the United States could improve. Some advice is to “make progress on the long-run fiscal situation…make it easier for people to immigrate…and invest in infrastructure.”

There is no golden place for investment all the time, but it’s useful to understand the pros and cons when deciding where to put your money.  Especially given the current strength in the dollar, you could do worse than domestic companies.

American companies have some structural advantages

Source: hotzoneonline

(For those of you interested in investing domestically, we offer two U.S. relative strength ETFs (PDP and DWAS) and a full suite of separate account options.  Give Andy a call.  He’s been a little lonely lately!)

Please see for more information.  A list of all holdings for the trailing 12 months is available upon request.  The Dorsey Wright SmallCap Technical Leaders Index is calculated by Dow Jones, the marketing name and a licensed trademark of CME Group Index Services LLC (“CME Indexes”).  “Dow Jones Indexes” is a service mark of Dow Jones Trademark Holdings LLC (“Dow Jones”).  Products based on the Dorsey Wright SmallCap Technical Leaders IndexSM, are not sponsored, endorsed, sold or promoted by CME Indexes, Dow Jones and their respective affiliates make no representation regarding the advisability of investing in such product(s).

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

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Not Investing?

August 3, 2012

After poor stock market performance over the past few years, many investors are holding on to cash. A survey by BlackRock ranks the reasons why people aren’t investing, and the results may be different from what you had expected.

  Uncertainty about where to invest (37%)

  Belief that it’s a poor investing environment (26%)

  Fear of investing/losing money (23%)

  Previous portfolio losses (8%)

  Not applicable, have not pulled back on investment activity (6%)

Investors are not completely closed off to the idea of investing, but instead don’t know where they should put their money.  One of the chief benefits of employing a relative strength strategy is that it provides the framework for allocating assets–thereby removing the biggest stumbling block to getting investors in the game.

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Assets in Model ETF Portfolios up 43%

June 19, 2012

Investment News reports that assets in model ETF portfolios tracked by Morningstar Inc. grew to $46 billion by the end of the first quarter, up 43% from a year earlier.

The growing popularity of exchange-traded funds has led to a boom among money managers who specialize in using low-cost passive investments to build go-anywhere portfolios.

These model ETF portfolios typically use ETFs to invest globally across all asset classes, such as equities, fixed income and commodities, to shoot for a real return.

Financial advisers increasingly are outsourcing some of their client assets to these managers so that they can spend more time on clients and less time managing portfolios.

“As the ETF landscape has gotten more complicated, not all advisers feel comfortable building their own portfolios,” said Sue Thompson, head of iShares’ RIA Group. “Advisers have to either be the expert or find one.”

Managing go-anywhere portfolios is near and dear to our hearts here at Dorsey Wright.  Click here to view a video presentation on our Global Macro portfolio, which has become our most widely used separate account strategy.

To receive the brochure for our Global Macro strategy, click here.  For information about the Arrow DWA Tactical Fund (DWTFX), click here.

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

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Relative Strength, Decade by Decade

June 5, 2012

This post explores relative strength success by decade, dating back to the 1930s.  Once again, we’ve used the Ken French data library and CRSP database data.  You can click here  for a more complete explanation of this data.

Chart 1: Percent Outperformance by Decade.  This chart shows the number of years in which relative strength has outperformed the CRSP universe each decade.  RS outperformance has occurred in at least half of all years each decade.

Chart 2: Average 1-Year Performance by Decade.  This chart shows the average yearly growth by decade of a relative strength portfolio and of the CRSP universe.  Each decade, the average performance of relative strength has been greater than the average performance of the CRSP universe.  Generally speaking, when the market’s average performance is increasing, RS outperforms CRSP by a greater percentage than it does when the market is doing poorly.

In short, relative strength has been a durable return factor for a very long time.

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The Art of Doing Nothing

June 5, 2012

The Wall Street Journal had a fascinating article over the weekend on a training simulation for pension plan trustees.  Teams compete with one another, with advice and guidance from employees of Brandes Investment Partner, the developers of the simulation.  What participants should focus on—and what they do focus on—are often two different things.

What the participants should focus on, [Brandes research analyst Nick Magnuson] says, are the results over longer periods and the information they have about the people, philosophy and processes at the 13 hypothetical money-management firms. In most cases, long-term performance is “a byproduct” of those aspects, Mr. Magnuson explains, while short-term results can be “noisy” rather than predictive.

Yet, the trustees playing the simulation often find that it’s hard to resist a manager on a hot streak—and it’s tempting to dump a long-term winner in a slump. Typically, when Brandes conducts what it calls its Manager Challenge, at least one-third of the teams pick managers based on three-year records, says Barry Gillman, a consultant to Brandes who previously was head of the firm’s portfolio strategies group. “The ingrained patterns are too hard to break,” he says.

The key to success, as it is so often, is being thoughtful about your decisions and then sticking with them.

Participants in these investing simulations, as in the real world, tend to trade too much, the Brandes officials say. Last month, some teams made 10 trades a round. By contrast, the winning team made a total of just five trades after picking its initial portfolio—the fewest in the game.

Sometimes even less trading has paid off. At a few contests in the past, the Brandes folks saw teams select their initial portfolios, slip out of the room to spend their time elsewhere, and come back to find themselves the winners. “We don’t really want people to figure that out” and miss out on the full experience, Mr. Gillman says. “But the reality is many of them would really be better off doing that.”

Winning by doing nothing should be a big lesson to all investors.  Select your managers carefully based on people, philosophy, and process (we happen to like relative strength)—and then leave it alone.  Assuming the people haven’t turned over and the philosophy and process are unchanged, that should be simple to do.  All too often, however, it is not done.

Look at it this way: financial markets are going to bounce up and down no matter what managers you select.  Sometimes markets will be smooth for extended periods; at other times they will be frustrating and turbulent.  Again, this will occur regardless of the managers you select.  You cannot let your confidence in the process be derailed by the inevitable bumps in the market.

There is a fine art to doing nothing.  Resisting the urge to tinker once your due diligence is complete actually requires a conscious decision not to intervene at each temptation.  It’s harder than it looks—and that’s often the difference between winning and losing.

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Stellar Performance—Out of the Limelight

June 4, 2012

Ron Lieber of the NYT explains his surprise that some of the biggest winners over the last 30 years are not the companies that get all the hype:

This week, I asked Wilshire Associates to look back 30 years to the beginning of the big bull run in stocks and figure out which of the companies in its index of more than 5,000 American enterprises had performed best over that stretch.

My guess is that you haven’t heard of half of the Top 10.

Back in 1982, would you have staked your claim on Danaher, the conglomerate that comes in at No. 3? Or might you have waited a few more years, until it was loaded up with debt courtesy of Michael Milken, the onetime junk bond king?

What about Apco Oil & Gas at No. 4? Or Precision Castparts at No. 7? Or maybe the high-tech balloons made by Raven Industries at No. 8 would have been more your taste. Ever heard of HollyFrontier at No. 10?

You get the idea. To have earned the 21 to 26 percent annualized returns (including reinvested dividends) that these companies delivered to investors over the last 30 years, you would have had to pick them out, invest enough to move the needle in your portfolio and then be smart enough to hang on.

Let’s start with selecting the stocks. The top-performing stock on the Wilshire list is Home Depot. Was anyone pointing at that company back in the early 1980s and insisting that it was going to the moon?

“Oh no,” said Arthur Blank, one of Home Depot’s founders, when I asked him this week. “We had no idea that was going to happen. When we went public in 1981, we only had eight stores.”

Indeed, the best investments are often the ones that few people have heard of, and sometimes the companies like it that way.

One of the benefits of building portfolios based on relative strength ranks is that the amount of hype that a company receives has no impact on whether or not the company is included in the portfolio.  Certainly, some on that list have received considerable amounts of attention, like Apple, but I think Lieber is right that many of the other names are off the radar of many investors.  A relative strength ranking system is a true meritocracy where securities are added and removed from portfolios based on one essential criteria—performance of that security relative to all other securities in the investment universe.

Dorsey Wright currently owns a number of the securities listed above.  A list of all holdings for the trailing 12 months is available upon request.

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Relative Strength vs. Value – Performance Over Time

May 31, 2012

Thanks to the large amount of stock data available nowadays, we are able to compare the success of different strategies over very long time periods. The table below shows the performance of two investment strategies, relative strength (RS) and value, in relation to the performance of the market as a whole (CRSP) as well as to one another. It is organized in rolling return periods, showing the annualized average return for periods ranging from 1-10 years, using data all the way back to 1927.

The relative strength and value data came from the Ken French data library. The relative strength index is constructed monthly; it includes the top one-third of the universe in terms of relative strength.  (Ken French uses the standard academic definition of price momentum, which is 12-month trailing return minus the front-month return.)  The value index is constructed annually at the end of June.  This time, the top one-third of stocks are chosen based on book value divided by market cap.  In both cases, the universes were composed of stocks with market capitalizations above the market median.

Lastly, the CRSP database includes the total universe of stocks in the database as well as the risk-free rate, which is essentially the 3-month Treasury bill yield. The CRSP data serves as a benchmark representing the generic market return. It is also worthwhile to know that the S&P 500 and DJIA typically do worse than the CRSP total-market data, which makes CRSP a harder benchmark to beat.


Source:Dorsey Wright Money Management

The data supports our belief that relative strength is an extremely effective strategy. In rolling 10-year periods since 1927, relative strength outperforms the CRSP universe 100% of the time.  Even in 1-year periods it outperforms 78.6% of the time. As can be seen here, relative strength typically does better in longer periods. While it is obviously possible do poorly in an individual year, by continuing to implement a winning strategy time and time again, the more frequent and/or larger successful years outweigh the bad ones.

Even more importantly, relative strength typically outperforms value investment. Relative strength defeats value in over 57% of periods of all sizes, doing the best in 10-year periods with 69.3% of trials outperforming. While relative strength and value investment strategies have historically both generally beat the market, relative strength has been more consistent in doing so.

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How Safe Is Your Pension?

May 31, 2012

From “How Safe Is Your Pension?” in the July 2012 Consumer Reports, comes a stark assessment of the current pension landscape:

If you’re counting on a traditional defined-benefit pension, there’s reason to worry that you might not get everything you’ve earned.  About 80 percent of the 29,000 private-sector defined-benefit plans insured by the federal Pension Benefit Guaranty Corp. have been underfunded by $740 billion.  State and local public employee pensions were recently in a $1 trillion hole.

Instead of beefing up plan assets, many companies have cut benefits.  Employers can change their pension rules going forward using a variety of tactics, including tinkering with benefit formulas so that your eventual payout will be reduced, “freezing” the plan to stop further accruals, or terminating an underfunded plan.

“Vested” pension assets—those that legally become your property after a period of time—are generally safe thanks to federal law.  But if the plan is terminated, the PBGC, which itself is $26 billion in the red, is required to pay vested benefits only up to a certain amount, which varies by the employee’s age and the year in which the plan is terminated.

Pensions of government workers aren’t covered by the agency but are often protected by state constitutions or laws.  Still, 26 states have squeezed benefits for new hires, some other workers, and retirees.

Finding ways to back out of promised retirement benefits and/or reducing benefits for new hires is going to be a dominant theme in the pension world for many years to come.  For a flavor of current pension reform efforts consider the current proposal for public employees in Illinois:

Gov. Pat Quinn is proposing to raise the retirement age to 67 from 55; cap retirees’ annual cost-of-living increases at the lesser of 3% or half of the consumer price index; and increase workers’ pension contributions by three percentage points. But what makes these reforms bolder than most other states’ is that they would apply to current employees in addition to future hires.

As financial advisors, we are in a unique position to help people deal with these realities.  Right at the top of the list of things that we can do to truly help our clients is to help them come to terms with the pension reforms that are and will be taking place in the coming years and adopt an appropriate savings and investment plan that accounts for these changes. The pressures to scale back pension benefits will be like nothing seen by the last generation of retirees.

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From the Archives: The Math Behind Manager Selection

May 31, 2012

Hiring and firing money managers is a tricky business.  Institutions do it poorly (see background post here ), and retail investors do it horribly (see article on DALBAR  ).  Why is it so difficult?

This white paper on manager selection from Intech/Janus goes into the mathematics of manager selection.  Very quickly it becomes clear why it is so hard to do well.

Many investors believe that a ten-year performance record for a group of managers is sufficiently long to make it easy to spot the good managers. In fact, it is unlikely that the good managers will stand out.  Posit a good manager whose true average relative return is 200 basis points (bps) annually and true tracking error (standard deviation of relative return) is 800 bps annually. This manager’s information ratio is 0.25. To put this in perspective, an information ratio of 0.25 typically puts a manager near or into the top quartile of managers in popular manager universes.

Posit twenty bad managers with true average relative returns of 0 bps annually, true tracking error of 1000 bps annually, hence an information ratio of 0.00.

There is a dramatic difference between the good manager and the bad managers.

The probability that the good manager beats all twenty bad managers over a ten-year period is only about 9.6%.  This implies that chasing performance leaves the investor with the good manager only about 9.6% of the time and with a bad manager about 90.4% of the time.

In other words, 90% of the time the manager with the top 10-year track record in the group will be a bad manager!  Maybe a longer track record would help?

A practical approach is to ask how long a historical performance record is necessary to be 75% sure that the good manager will beat all the bad managers, i.e., have the highest historical relative return. Assuming the same good manager as before and twenty of the same bad managers as before, a 157 year historical performance record is required to achieve a 75% probability that the good manager will beat all the bad managers.

It turns out that it would help, but since none of the manager databases have 150-year track records, in practice it is useless.  The required disclaimer that past performance is no guarantee of future results turns out to be true.

There is still an important practical problem to be solved here.  Assuming that bad managers outnumber good ones and assuming that we don’t have 150 years to wait around for better odds, how can we increase our probability of identifying one of the good money managers?

The researchers show mathematically how combining an examination of the investment process with historical returns makes the decision much simpler.  If the investor can make a reasonable assumption about a manager’s investment process leading to outperformance, the math is straightforward and can be done using Bayes’ Theorem to combine probabilities.

…the answer changes based on the investor’s assessment of the a priori credibility of the manager’s investment process.

It turns out that the big swing factor in the answer is the credibility of the underlying investment process.  What are the odds that an investment process using Fibonacci retracements and phases of the moon will generate outperformance over time?  What are the odds that relative strength or deep value will generate outperformance over time?

The research paper concludes with the following words of wisdom:

A careful examination of almost any investor’s investment manager hiring and firing process is likely to reveal that there is a substantial component of performance chasing. Sometimes it is obvious, e.g., when there is a policy of firing a manager if he has negative performance after three years. Other times it is subtle, e.g., when the initial phase of the manager search process strongly weights attractive historical performance. No matter the form that performance chasing takes, it tends to produce future relative returns that are disappointing compared to expectations.

Historical performance alone is not an effective basis for identifying a good manager among a group of bad managers. This does not mean that historical performance is useless. Rather, it means that it must be combined efficiently with other information. The correct use of historical performance relegates it to a secondary role. The primary focus in manager choice should be an analysis of the investment process.  [emphasis added]

This research paper is eye-opening in several respects.

1) It shows pretty clearly that historical performance alone–despite what our intuition tells us–is not sufficient to select managers.  This probably accounts for a great deal of the poor manager selection, the subsequent disappointment, and rapid manager turnover that goes on.

2) It is very clear from the math that only credible investment processes are likely to generate long-term outperformance.  Fortunately, lots of substantive academic and practitioner research has been done on factor analysis leading to outperformance.  The only two broadly robust factors discovered so far have been relative strength and value, both in various formulations–and, obviously, they have to be implemented in a disciplined and systematic fashion.  If your investment process is based on something else, there’s a decent chance you’re going to be disappointed.

3) Significant time is required for the best managers to stand out from the much larger pack of mediocre managers.

This is a demanding process for consultants and clients.  They have to willfully reduce their focus on even 10-year track records, limit their selection to rigorous managers using proven factors for outperformance, and then exercise a great deal of patience to allow enough time for the cream to rise to the top.  The rewards for doing so, however, might be quite large–especially since almost all of your competition will ignore the correct process and and simply chase performance.

—-this article originally appeared 1/28/2010.  I have seen no evidence since then that most consultants have improved their manager selection process, which is a shame.

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Hedge Fund Alternatives

May 29, 2012

From Barron’s, an interesting insight into the alternative space:

Investor interest in hedge-fund strategies has never been higher—but it’s the mutual-fund industry that seems to be benefiting.

Financial advisors and institutions are increasingly turning to alternative strategies to manage portfolio risk, though the flood of money into that area tapered off a bit last year, according to an about-to-be-released survey of financial advisors and institutional managers conducted by Morningstar and Barron’s. Many of them are finding the best vehicle for those strategies to be mutual funds.

Very intriguing, no?  There are quite a few ways now, through ETFs or mutual funds, to get exposure to alternatives.  We’ve discussed the Arrow DWA Tactical Fund (DWTFX) as a hedge fund alternative in the past as well.  Tactical asset allocation is one way to go, but there are also multi-strategy hedge fund trackers, macro fund trackers, and absolute-return fund trackers, to say nothing of managed futures.

Each of these options has a different set of trade-offs in terms of potential return and volatility.  For example, the chart below shows the Arrow DWA Tactical Fund, the IQ Hedge Macro Tracker, the IQ Hedge Multi-Strategy Tracker, and the Goldman Sachs Absolute Return Fund for the maximum period of time that all of the funds have overlapped.

(click on image to enlarge)

You can see that each of these funds moves differently.  For example, the Arrow DWA Tactical Fund, which is definitely directional, has a very different profile than the Goldman Sachs Absolute Return Fund, which presumably is not (as) directional.

Very few of these options were even available to retail investors ten years ago.  Now they are numerous, giving individuals the opportunity to diversify like never before.  With proper due diligence, it’s quite possible you will find an alternative strategy that can improve your overall portfolio.

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From the Archives: Is Modern Portfolio Theory Obsolete?

May 29, 2012

It all depends on who you ask.  Apologists for MPT will say that diversification worked, but that it just didn’t work very well last go round.  That’s a judgment call, I suppose.  Correlations between assets are notoriously unstable and nearly went to 1.0 during the last decline, but not quite.  So I guess you could say that diversification “worked,” although it certainly didn’t deliver the kind of results that investors were expecting.

Now even Ibbotson Associates is saying that certain aspects of modern portfolio theory are flawed, in particular using standard deviation as a measurement of risk.  In a recent Morningstar interview, Peng Chen, the president of Ibbotsen Associates, addresses the problem.

It’s one thing to say modern portfolio theory, the principle, remained to work. It’s another thing to examine the measures. So when we started looking at the measures, we realized, and this has been documented by many academics and practitioners, we also realized that one of the traditional measures in modern portfolio theory, in particular on the risk side, standard deviation, does not work very well to measure and present the tail risks in the return distribution.

Meaning that, when you have really, really bad market outcomes, modern portfolio theory purely using standard deviation underestimates the probability and severity of those tail risks, especially in short frequency time periods, such as monthly or quarterly.

Leaving aside the issue of how the theory could work if the components do not, this is a pretty surprising admission.  Ibbotson is finally getting around to dealing with the “fat tails” problem.  It’s a known problem but it makes the math much less tractable.  Essentially, however, Mr. Chen is arguing that market risk is actually much higher than modern portfolio theory would have you believe.

In my view, the debate about modern portfolio theory is pretty much done.  Stick a fork in it.  Rather than grasping about for a new theory, why not look at tactical asset allocation, which has been in plain view the entire time?

Tactical asset allocation, when executed systematically, can generate good returns and acceptable volatility without regard to any of the tenets of modern portfolio theory.  It does not require standard deviation as the measure of risk, and it makes no assumptions regarding the correlations between assets.  Instead it makes realistic assumptions: some assets will perform better than others, and you ought to consider owning the good assets and ditching the bad ones.  It’s the ultimate pragmatic solution.

—-this article originally appeared 1/21/2010.  As we gain distance from the 2008 meltdown, investors are beginning to forget how badly their optimized portfolios performed and are beginning to climb back on the MPT bandwagon.  Combining uncorrelated strategies always makes for a better portfolio, but the problem of understated risk remains.  The tails are still fat.  Let’s hope that we don’t get another chance to experience fat tails with the Eurozone crisis.  Tactical asset allocation, I think, may still be the most viable solution to the problem.

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From the Archives: Inflation Rears Its Ugly Head

May 25, 2012

Howard Marks is chairman of Oaktree Capital, a large and well-known institutional alternative fixed income manager.  Mr. Marks’s memos are always thoughtful and worth reading.  This go round he has a discussion of all of the things that could go wrong with the world economy—essentially a list of all of the things that could go wrong.  One of the things that could go wrong is inflation.

He believes rates are more likely to go higher than lower, and that inflation, long forgotten as a risk factor, might return.  In addition, he has a list of suggestions on how to deal with inflation including TIPs, floating rate debt, gold, real assets like commodities, oil, and real estate, and foreign currencies.  His catalog of alternatives is even longer, but you get the idea.  (If you want to read the whole memo, you can find it here.)

That’s quite a list, but the first thing that I noticed about it is that not one of these items is generally considered as an investment option by retail investors.  Most investors are mentally stuck in the domestic stocks/domestic bonds arena.  Diversification consists of hitting more than one Morningstar style box.  If inflation does come back, that’s not going to cut it.  In fact, Mr. Marks asks investors, “How much of your portfolio are you willing to devote to protect against these macro forces?”  He says if the answer is 5%, or 10%, or 15% that those levels are pretty close to doing nothing.  He thinks a portfolio will need to devote at least 30-40% of assets toward inflation protection if it recurs.

Investment flexibility and risk diversification were the primary reasons that we launched the Systematic RS Global Macro account as a retail product last year.  Many of the inflation hedges in Mr. Marks’ list are asset classes that are available in the Global Macro portfolio, including TIPs, gold, commodities, oil, real estate, and foreign currencies.  Given our basket rotation strategy and our adherence to relative strength, the Global Macro portfolio could easily have 40% of its assets, or more, in inflation hedges if inflation were to recur.  I think the jury is still out about how the world economy will respond to decreased levels of fiscal stimulus, but it’s good to know that you have options.

—-this article originally appeared 1/25/2010.  We have not seen runaway inflation so far, but the point Howard Marks makes is valid.  If/when inflation does occur, you might need to devote a lot of your portfolio to inflation protection.  Is your investment process up for the challenge?

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There Were These Megatrends…

May 24, 2012

American Funds is one of the largest and most respected mutual fund companies around.  One of their portfolio managers, Jim Dunton, is retiring after 50 years.  I love these sorts of articles because of the tremendous perspective that long-time investors have.  (That’s part of the reason that Warren Buffett’s annual reports are such a hoot.)

Jim Dunton of American Funds reflecting on his 50 years in the investment business:

There were these megatrends — including the Cold War, inflation and energy — that both continued for a long period of time and then aborted and went in the other direction. The Cold War began around 1946 and continued all the way until 1990 when the Berlin Wall came down. Much happened during that period that affected the investment business. There were hot wars in Korea and Vietnam. But also important were the many scientific developments that came out of the Cold War — like satellites, GPS and aerospace advances — that we were able to invest in over the period.

With inflation, we had one long trend of almost no inflation from the 1930s, a build of inflation from the mid-60s to the early 1980s, and then a great dénouement from then until now. Inflation was matched, of course, by interest rates which were around 2% in the 1950s, went to 12% in 1980 and now are back down to 2% again.

Another key trend was energy. After the 1973 oil embargo, oil prices went from $3 per barrel to $36. The biggest input cost in the world went up 12 times almost overnight, and that fed further into high inflation. In 1979, we were consuming about 18.5 million barrels of oil per day in this country. The rise in oil prices was so significant that the resulting changes in automobile technology and alternative resources have meant that today oil consumption is back to about 18.5 million barrels.

Fantastic.  Investors worry all the time about trend following somehow ceasing to work.  But an experienced investor like Mr. Dunton can look back on 50 years and see a number of megatrends that made a big difference in the investment process.  That probably won’t change.  Relative strength remains one of the best ways to identify and participate in big trends.

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Tactical Management and Flawed Forecasting

January 26, 2012

Bob Veres is a highly respected columnist for Financial Planning magazine.  He’s been in the forefront of advocating good practices in financial planning.  He had an interesting article about the dangers of tactical management last month–and the longer I chew over that article, the more problems I see with forecasting, explicit and implicit.

First, let me set the scene for you.  Mr. Veres indicated that he had spent a month doing data analysis of a survey of over 1000 financial planners.  One of the most interesting takeaways:

Perhaps the most striking thing I learned is that, post-2008, activities once labeled “market timing” are now solidly in the mainstream.  No, planners are not moving into or out of the market based on reading the entrails of animal sacrifices. But they seem to be taking a much more active approach to protecting clients from downside risk. The survey asked whether advisors planned to raise or lower their allocations to each of 35 different investment classes or vehicles in the next three months. A remarkable 83% are anticipating at least one tactical adjustment – and the great majority expects to make several.

Mr. Veres raises a legitimate question about how accurate planner’s forecasts are, and what the possible consequences of poor forecasts could be.  As an example, he cites inflation forecasts:

One of the most provocative set of responses came when advisors were asked to forecast the inflation rate and the real (after-inflation) return of both equities and 10-year Treasuries over the next 10 years. On inflation, the majority of responses clustered between 3% and 5%, and the remaining responses had a center of gravity on the 6% to 7% part of the chart. If there is wisdom in the crowd, the crowd of advisors seems to believe we will experience above-average inflation for at least the remainder of this decade.

But we also had responses as low as -4% a year (projecting severe Japanese-style deflation), several as high as 10% and one advisor who anticipates annual inflation of 13% over the coming decade. One or the other group on the fringes is going to be spectacularly wrong (or both will), and I suspect that damaging consequences will show up in the portfolios they recommend.

He is absolutely correct in his belief that a strategic allocation based on a wildly incorrect forecast will be damaging to a client.  And, he indicated that expectations for real returns were even more widely dispersed.  It’s where he goes next that made me think.  He writes:

Say what you will about the buy-and-hold ethos that lasted until September 2008. It may not have been an ideal strategy during the worst of the bear markets, but it did keep the members of the herd from straying too far from the center – and, more important, it kept the profession from getting the kinds of black eyes I think advisors are going to encounter in the future.

I think there is a critical error in this line of thinking.  Buy-and-hold strategic allocations are typically based on historic returns.  Those historic returns, of course, are the same for everybody and they do have the effect of keeping everyone in the middle of the herd.

This is the critical error: basing your allocation on historic returns is also a forecast–it’s simply an implicit forecast that historic returns will continue along the same path!  If that doesn’t happen, you will end up just as horribly wrong as the advisors on the forecasting fringes!  Yes, you will fail conventionally along with everyone else in the middle of the herd, but you will fail nonetheless.  (How do you think most clients feel right now, with their equity allocations based for the last decade on an 8-10% historic return, a return that has not materialized?  And there’s always Japan.)

Frankly, if you’re going to do strategic asset allocation at all, research shows that naive equal-weighting performs as well as anything else.  The reason advisors are gravitating toward tactical management in the first place is because traditional strategic asset allocation has so much trouble with tail events, and 2008-2009 was a big tail event.  Clients have memories, and advisors are simply responding to client demand for a more active form of risk management.  Now, like Mr. Veres, I’m not very confident in the forecasting abilities of financial planners.  I’m not very confident in the forecasting abilities of anyone, for that matter, including me.

All forecasting is flawed, whether it is explicit or implicit.  To me, there are only two realistic choices for asset allocation.  Either 1) equal-weight a large number of asset classes and rebalance periodically or 2) commit to a systematic method of tactical asset allocation.  There are funds that use valuation triggers and funds that use relative strength to rotate among asset classes–and I suspect either will perform acceptably over time if it is systematic and disciplined.

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Momentum Over Multiple Cycles

November 23, 2011

In a recent interview, Jim O’Shaughnessy made the case for following quantitative strategies that have performed well over multiple market cycles:

The average investor does significantly worse than a simple index … It’s literally because of the way our brains are wired. As [neuro-finance researchers] look at super-fast scans of the brain making decisions under uncertainty, we see that even with a so-called professional investor making the choice, it is not the rational centres of the brain that fire when they’re making those choices. It is the emotional centres of the brain.

That’s one of the reasons why finding good strategies that have performed well over multiple market cycles – and then having the ability to stick with them through thick and thin, even when they’re not working for you – is the key to good long-term success.

Which brings me to the long-term performance of relative strength strategies.  We tracked down total return data for the S&P 500 going back to 1930 and compared it to the momentum series on the website of Ken French at Dartmouth (top half in market cap, top 1/3 in momentum).  The chart below shows 10-year rolling returns, which is why it starts in 1940.  The average ten-year returns?  405% for relative strength and 216% for the S&P 500, a near doubling!  That’s without the momentum series getting any credit for dividends.  Even more impressive, the ten-year rolling return of the relative strength series outperformed in 100% of the time periods.

Click to enlarge

Source:  J.P. Lee, Dorsey, Wright Money Management

Results such as these should provide more than enough confidence to stick with relative strength through the thick and thin.

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Dare to be Different

July 28, 2011

Advisor Perspectives ran a recent article by Sitka Pacific’s J.J. Abodeely.  There was a fantastic quotation he pulled out from Ben Inker at GMO:

“The good news is that in the investment business there are very few people who do real asset allocation and actually move money around in an aggressive way,” Inker said. “It’s a tough thing to do and survive. The nice thing about it, and the reason why we do it, is because this means it’s an inefficiency that is not going to get arbitraged away anytime soon.”

We’ve written in the past about this exact feature of many winning investment strategies: the arbitrage involved is behavioral, not financial.  Good returns derived from uncomfortable strategies do not get arbitraged away, because very few people will actually do it.  In other words, if you look at your portfolio and get a warm, fuzzy feeling, you’re probably doing it wrong.

Simple examples of this phenomenon abound.  Here’s one: to lose weight 1) eat less and 2) exercise more.  Have I now arbitraged away the entire diet book industry because I just gave you the basic advice for free?  Of course not!  When I searched Amazon for “The * Diet,” I got 65,338 results (!!), ranging from The Warrior Diet to Crazy Sexy Diet to The Juice Lady’s Turbo Diet.  Although I am in awe of publishers’ ingenuity in coming up with great book titles, none of these diets will necessarily work any better than my basic advice.  The reason people struggle to lose weight is not because reasonable advice is not readily available; it’s because the advice is hard to implement.  Eating less and exercising more is simply less comfortable than our default position of eating more and exercising less!

Relative strength is often an uncomfortable strategy whether it is implemented in equities or global asset classes simply because the portfolios can deviate significantly from the market or from traditional notions of asset allocation.  On the plus side, it may give you some comfort to realize that relative strength methods have shown excellent returns for many decades—returns that are not likely to be arbitraged away unless human nature undergoes a substantial change.

Dare to be different


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The #1 Investment Return Factor No One Wants to Talk About

June 29, 2011

Relative strength is the #1 investment return factor no one wants to talk about.  The reasons are not entirely clear to me, but perhaps it is because it is too simple.  It does not require a CFA to forecast earnings or to determine an economic moat.  It does not require a CPA to attempt to assess valuation.  It does not require an MBA to assess strategic business decisions.  In short, it does not play to the guild mentality wherein only certain masters of the universe have the elevated intellect, knowledge, and background to invest successfully.

Although relative strength is simple, I am not suggesting that relative strength is easy to implement.  Losing weight is simple too: eat less, exercise more.  That does not make it easy to do.  Relative strength, probably like most successful investment strategies, requires an inordinate amount of discipline—and tolerance of a fair amount of randomness.  Like most games that are easy to learn, but difficult to master—chess would be an apt example—proficient use of relative strength also requires deep study and experience.

Yet relative strength has been used successfully by practitioners for many generations.  George Chestnutt of the American Investors Fund began using it to run money in the 1930s and said it had been in use by others for at least a generation before that.  Relative strength has been shown to work in many asset classes, across many markets for more than 100 years.  Since the early 1990s, even academics have gotten in on the act.

And for all that, relative strength remains ignored.

I was reminded of its apparent obscurity again this week when reading an excellent article on indexing by the macrocephalic Rob Arnott.  He had a very nice piece in Advisor Perspectives about the virtues of alternative beta indexes.

In recent years, a whole new category of investments—called “alternative betas”—has emerged. Some of these alternative beta strategies, including the Fundamental Index® approach, use various structural schemes to select and/or weight securities in the index. In that sense, they fall between traditional cap-weighted approaches and active management: they pick up broadly diversified market exposure (beta) but seek to produce better results than cap-weighted indexes (what is desired from active managers).

Our CIO, Jason Hsu, and research staff have replicated the basic methodologies of many of these rules-based alternative betas, ranging from a simple equal-weighted approach to the straightforward Fundamental Index strategy to the truly exotic such as risk clustering and diversity weighting.7 The potential rewards are promising. Of the 10 non-cap-weighted U.S. equity strategies studied, all outperformed the passive cap-weighted benchmark. The range of excess returns by alternative beta strategies was between 0.4% and 3.0% per annum—matching a reasonable estimate of the top quartile of active managers—that is, the small cadre of managers who generally are successful at beating the benchmark (see Table 1). The bottom line: investors can obtain top-quartile performance with far less effort than is required to research and monitor traditional active equity managers.

Mr. Arnott has a very good point—and the numbers to prove it.  Lots of alternative beta strategies are available that can potentially offer top-quartile performance relative to other active managers and that may also outperform traditional passive cap-weighted benchmarks.  He is no doubt proselytizing on behalf of his firm’s Fundamental Index approach to some extent, but I think his underlying thesis is correct.  He offers the following table as evidence that alternative beta strategies can outperform, using data from 1964- 2009:

Source: Advisor Perspectives, Research Affiliates (click to enlarge)

I would like to offer a slight modification of this table, since it is only a listing of “select” alternative beta strategies.  Relative strength has been inexplicably excluded. Below, I present the same table of alternative beta strategies now including relative strength, the #1 investment return factor no one wants to talk about.  (I have my own theory about why other indexers don’t want to talk about relative strength, but I will let you reach your own conclusions.)  The relative strength returns presented in the table are for the exact same time period, 1964 through 2009.  They are taken from Professor Ken French’s database and show the results of a simple relative strength selection process when using the top third (as ranked by relative strength) of the large cap universe.

Source: Research Affiliates, Dorsey Wright (click to enlarge)

Are you surprised that relative strength blows away the other alternative beta strategies?

You shouldn’t be.  There are plenty of academic and practitioner studies attesting to the power of relative strength.  In short, I agree with Mr. Arnott that alternative beta indexes are worth a close look.  And I think it would be particularly prudent to consider relative strength weighted indexes.

See for more information on our three DWA Technical Leaders Index ETFs (PDP, PIE, PIZ).

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

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