Is Sector Rotation a Crowded Trade?

January 16, 2014

As sector ETFs have proliferated, more and more investors have been attracted to sector rotation and tactical asset allocation strategies using ETFs, whether self-managed or implemented by an advisor.  Mark Hulbert commented on sector rotation strategies in a recent article on Marketwatch that highlighted newsletters using Fidelity sector funds.  All of the newsletters had good returns, but there was one surprising twist:

…you might think that these advisers each recommended more or less the same basket of funds. But you would be wrong. In fact, more often than not, each of these advisers has tended to recommend funds that are not recommended by any other of the top five sector strategies.

That’s amazing, since there are only 44 actively managed Fidelity sector funds and these advisers’ model portfolios hold an average of between five and 10 funds each.

This suggests that there is more than one way of playing the sector rotation game, which is good news. If there were only one profitable sector strategy, it would quickly become so overused as to stop working.

This is even true among those advisers who recommend sectors based on their relative strength or momentum. Because there are so many ways of defining these characteristics, two different sector momentum strategies will often end up recommending two different Fidelity sector funds.

Another way of appreciating the divergent recommendations of these top performing advisers is this: Of the 44 actively managed sector funds that Fidelity currently offers, no fewer than 22 are recommended by at least one of these top five advisers. That’s one of every two, on average, which hardly seems very selective on the advisers’ part.

Amazing, isn’t it?  It just shows that there are many ways to skin a cat.

Even with a very limited menu of Fidelity sector funds, there was surprisingly little overlap.  Imagine how little overlap there would be within the ETF universe, which is much, much larger!  In short, you can safely pursue a sector rotation strategy (and, by extension, tactical asset allocation) with little concern that everyone else will be plowing into the same ETFs.

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Price Persistence At the Asset Class Level

January 9, 2014

Leuthold’s January Green Book includes a simple, yet compelling study about applying momentum at the asset class level:

While even academics now acknowledge the existence of a “price persistence” effect at the stock and industry group level, it is less well known that the phenomenon exists at the broad asset class level.  We’ve examined a few simple approaches in which allocation decisions are based purely on the prior year’s total return performance of seven asset classes: Large Caps, Small Caps, Foreign Stocks, REITs, Commodities, Gold and U.S. Treasury Bonds.  Contrarians might be surprised to learn that a turnaround strategy of buying last year’s laggards (the #5, #6 and #7 performers), has been a consistently poor approach for the last 40 years.  Meanwhile, a naive, momentum-surfing strategy of buying last year’s #1 or #2 performer (or both) has soundly beaten the S&P 500 since 1973.  (We suspect these results are especially humbling to those who spend the rest of the year building and monitoring elaborate tools that track valuations, the economic cycle, investor sentiment, etc.)

Leuthold Table 1

(printed with permission from Leuthold)

Bottom line: momentum also works well at the asset class level.  Click here for a white paper written by John Lewis that also confirms that momentum can be successfully applied to a group of asset classes.

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DWA Technical Leaders Index Trade Profiles

January 6, 2014

The Dorsey, Wright Technical Leaders Index is composed of a basket of 100 mid and large cap securities that have strong relative strength (momentum) characteristics.  Each quarter we reconstitute the index by selling stocks that have underperformed and by adding new securities that score better in our ranking system.  We began calculating the index in real-time at the end of 2006.  Over the last seven years there have been quite a few deletions and additions as the index has adapted to some very dynamic market conditions.

Any relative strength or momentum-based investment strategy is a trend following strategy.  Trend following has worked for many years in financial markets (although not every year).  These systems are characterized by a several common attributes: 1) Losing trades are cut quickly and winners are allowed to run, 2) there are generally a lot of small losing trades, and 3) all of the money is made by the large outliers on the upside.  When we look at the underlying trades inside of the index over the years we find exactly that pattern of results.  There is a lot going on behind the scenes at each rebalance that is designed to eliminate losing positions quickly and maintain large allocations to the true winners that drive the returns.

We pulled constituent level data for the DWATL Index going back to the 12/31/2006 rebalance.  For each security we calculated the return relative to the S&P 500 and how many consecutive quarters it was held in the index.  (Note: stocks can be added, removed, and re-added to the index so any individual stock might have several entries in our data.)  The table below shows summary statistics for all the trades inside of the index over the last seven years:


The data shows our underlying strategy is doing exactly what a trend following system is designed to accomplish.  Stocks that aren’t held very long (1 to 2 quarters), on average, are underperforming trades.  But when we are able to find a security that can be held for several quarters, those trades are outperformers on average.  The whole goal of a relative strength process is to ruthlessly cut out losing positions and to replace them with positions that have better ranks.  Any investor makes tons of mistakes, but the system we use to reconstitute the DWATL Index is very good at identifying our mistakes and taking care of them.  At the same time, the process is also good at identifying winning positions and allowing them to remain in the index.

Here is the same data from the table shown graphically:


You can easily see the upward tilt to the data showing how relative performance on a trade-level basis improves with the time held in the index.  For the last seven years, each additional consecutive quarter we have been able to keep a security in the Index has led to an average relative performance improvement of about 920 basis points.  That should give you a pretty good idea about what drives the returns: the big multi-year winners.

We often speak to the overall performance of the Index, but we sometimes forget what is going on behind the scenes to generate that return.  The process that is used to constitute the index has all of the characteristics of a trend following system.  Underperforming positions are quickly removed and the big winning trades are allowed to remain in the index as long as they continue to outperform.  It’s a lot like fishing: you just keep throwing the small ones back until you catch a large one.  Sometimes it takes a couple of tries to get a keeper, but if you got a big fish on the first try all the time it would be called “catching” not “fishing.”  I believe part of what has made this index so successful over the years is there is zero human bias that enters the reconstitution process.  When a security needs to go, it goes.  If it starts to perform well again, it comes back.  It has no good or bad memories.  There are just numbers.

The performance numbers are pure price return, not inclusive of fees, dividends, or other expenses.  Past performance is no guarantee of future returns.  Potential for profit is accompanied by potential for loss.  A list of all holdings for the trailing 12 months is available upon request.

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Momentum and Dividends in Rising Rate Environments

October 14, 2013

In a low-interest rate environment, investors have naturally turned their attention to stocks paying high dividends as a way to generate income.  Momentum, as a return factor, has not been in the spotlight.  However, as interest rates have moved higher from their lows of last summer (On October 10, 2013 the 10-year US Treasury yield was 2.71% compared to 1.43% on July 25, 2012.), you might wonder how high dividend paying stocks tend to perform in rising rate environments over time.  A current trend chart of the 10-year U.S. Treasury Yield Index, shows that yields are trending higher.

10YR Yield

Source: Dorsey Wright

A longer-term chart of the 10-year US Treasury Yield Index is shown below:

10 Year Treasury Rates

Jim O’Shaughnessy’s What Works On Wall Street says this about high-yielders:

The high-yielders from Large Stocks do best in market environments in which value is outperforming growth, winning 74 percent of the time.  They also do well in markets in which bonds are outperforming stocks, winning 65 percent of the time in those environments.

O’Shaughnessy’s book lays out the performance of portfolios formed by a number of return factors since the 1920s.  His book includes the performance of portfolios formed by market capitalization, price-to-earnings ratios, EBITDA, price-to-cash flow ratios, price-to-sales ratios, price-to book ratios, dividend yields, relative strength (momentum), and many other factors.

In the rising interest rate environment of the 1960s and 1970s, O’Shaughessy shows the performance for the portfolio of the highest yielders as follows:


Source: What Works On Wall Street

Not bad—the dividend-focused portfolio was still able to generate modest outperformance.  However, a portfolio formed by price momentum was clearly able to generate much higher returns in a rising rate environment.  While this may not be the best environment for portfolios of high dividend payers to really stand out, investors may find that momentum can excel in rising-rate periods.   

Past performance is no guarantee of future returns.

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Dumb Talk About Smart Beta?

October 7, 2013

John Rekenthaler at Morningstar, who usually has some pretty smart stuff to say, took on the topic of smart beta in a recent article.  Specifically, he examined a variety of smart beta factors with an eye to determining which ones were real and might persist.  He also thought some factors might be fool’s gold.

Here’s what he had to say about value:

The value premium has long been known and continues to persist.

And here’s what he had to say about relative strength (momentum):

I have trouble seeing how momentum can succeed now that its existence is well documented.

The italics are mine.  I didn’t take logic in college, but it seems disingenuous to argue that one factor will continue to work after it is well-known, while becoming well-known will cause the other factor to fail!  (If you are biased in favor of value, just say so, but don’t use the same argument to reach two opposite conclusions.)

There are a variety of explanations about why momentum works, but just because academics can’t agree on which one is correct doesn’t mean it won’t continue to work.  It is certainly possible that any anomaly could be arbitraged away, but Robert Levy’s relative strength work has been known since the 1960s and our 2005 paper in Technical Analysis of Stocks & Commodities showed it continued to work just fine just the way he published it.  Academics under the spell of efficient markets trashed his work at the time too, but 40 years of subsequent returns shows the professors got it wrong.

However, I do have a background in psychology and I can hazard a guess as to why both the value and momentum factors will continue to persistthey are both uncomfortable to implement.  It is very uncomfortable to buy deep value.  There is a terrific fear that you are buying a value trap and that the impairment that created the value will continue or get worse.  It also goes against human nature to buy momentum stocks after they have already outperformed significantly.  There is a great fear that the stock will top and collapse right after you add it to your portfolio.  Investors and clients are quite resistant to buying stocks after they have already doubled, for example, because there is a possibility of looking really dumb.

Here’s the reason I think both factors are psychological in origin: it is absurdly easy to screen for either value or momentum.  Any idiot can implement either strategy with any free screener on the web.  Pick your value metric or your momentum lookback period and away you go.  In fact, this is pretty much exactly what James O’Shaughnessy did in What Works on Wall Street.  Both factors worked well—and continue to work despite plenty of publicity.  So the barrier is not that there is some secret formula, it’s just that investors are unwilling to implement either strategy in a systematic way–because of the psychological discomfort.

If I were to make an argument—the behavioral finance version—about which smart beta factor could potentially be arbitraged away over time, I would have to guess low volatility.  If you ask clients whether they would prefer to buy stocks that a) had already dropped 50%, b) had already gone up 50%, or c) had low volatility, I think most of them would go with “c!”  (Although I think it’s also possible that aversion to leverage will keep this factor going.)

Value and momentum also happen to work very well together.  Value is a mean reversion factor, while momentum is a trend continuation factor.  As AQR has shown, the excess returns of these two factors (unsurprisingly, once you understand how they are philosophical opposites) are uncorrelated.  Combining them may have the potential to smooth out an equity return stream a little bit.  Regardless, two good return factors are better than one!

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Long-Only Momentum

October 4, 2013

Gary Antonacci has a very nice article at Optimal Momentum regarding long-only momentum.  Most academic studies look at long-short momentum, while most practitioners (like us) use long-only momentum (also known as relative strength).  Partly this is because it is somewhat impractical to short across hundreds of managed accounts, and partly because clients don’t usually want to have short positions.  The article has another good reason, quoting from an Israel & Moskowitz paper:

Using data over the last 86 years in the U.S. stock market (from 1926 to 2011) and over the last four decades in international stockmarkets and other asset classes (from 1972 to 2011), we find that the importance of shorting is inconsequential for all strategies when looking at raw returns. For an investor who cares only about raw returns, the return premia to size, value, and momentum are dominated by the contribution from long positions.

In other words, most of your return comes from the long positions anyway.

The Israel & Moskowitz paper looks at raw long-only returns from capitalization, value, and momentum.  Perhaps even more importantly, at least for the Modern Portfolio Theory crowd, it looks at CAPM alphas from these same segments on a long-only basis.  The CAPM alpha, in theory, is the amount of excess return available after adjusting for each factor.  Here’s the chart:

Source: Optimal Momentum

(click on image to enlarge)

From the Antonacci article, here’s what you are looking at and the results:

I&M charts and tables show the top 30% of long-only momentum US stocks from 1927 through 2011 based on the past 12-month return skipping the most recent month. They also show the top 30% of value stocks using the standard book-to-market equity ratio, BE/ME, and the smallest 30% of US stocks based on market capitalization.

Long-only momentum produces an annual information ratio almost three times larger than value or size. Long-only versions of size, value, and momentum produce positive alphas, but those of size and value are statistically weak and only exist in the second half of the data. Momentum delivers significant abnormal performance relative to the market and does so consistently across all the data.

Looking at market alphas across decile spreads in the table above, there are no significant abnormal returns for size or value decile spreads over the entire 1926 to 2011 time period. Alphas for momentum decile portfolio spread returns, on the other hand, are statistically and economically large.

Mind-boggling right?  On a long-only basis, momentum smokes both value and capitalization!

Israel & Moskowitz’s article is also quoted in the post, and here is what they say about their results:

Looking at these finer time slices, there is no significant size premium in any sub period after adjusting for the market. The value premium is positive in every sub period but is only statistically significant at the 5% level in one of the four 20-year periods, from 1970 to 1989. The momentum premium, however, is positive and statistically significant in every sub period, producing reliable alphas that range from 8.9 to 10.3% per year over the four sub periods.

Looking across different sized firms, we find that the momentum premium is present and stable across all size groups—there is little evidence that momentum is substantially stronger among small cap stocks over the entire 86-year U.S. sample period. The value premium, on the other hand, is largely concentrated only among small stocks and is insignificant among the largest two quintiles of stocks (largest 40% of NYSE stocks). Our smallest size groupings of stocks contain mostly micro-cap stocks that may be difficult to trade and implement in a real-world portfolio. The smallest two groupings of stocks contain firms that are much smaller than firms in the Russell 2000 universe.

What is this saying?  Well, the value premium doesn’t appear to exist in the biggest NYSE stocks (the stuff your firm’s research covers).  You can find value in micro-caps, but the effect is still not very significant relative to momentum in long-only portfolios.  And momentum works across all cap levels, not just in the small cap area.

All of this is quite important if you are running long-only portfolios for clients, which is what most of the industry does.  Relative strength (momentum) is a practical tool because it appears to generate excess return over many time periods and across all capitalizations.

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Correlation and Expected Returns

July 31, 2013

Modern portfolio theory imagines that you can construct an optimal portfolio, especially if you can find investments that are uncorrelated.  There’s a problem from the correlation standpoint, though.  As James Picerno of The Capital Spectator points out, correlations are rising:

A new study from the Bank of International Settlements (BIS) raises doubts about the value of commodities as a tool for enhancing portfolio diversification. The paper’s smoking gun, so to speak, is that “the correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.”

Correlations are a key factor in the design and management of asset allocation, but they’re not the only factor. And even if we can find assets and strategies with reliably low/negative correlations with, say, equities, that alone isn’t enough, as I discussed last week. You also need to consider other factors, starting with expected return. It may be tempting to focus on one pair of assets and consider how the trailing correlation stacks up today. But that’s hardly the last word on making intelligent decisions on how to build a diversified portfolio.

As more investors pile into commodities, REITs, hedge funds, and other formerly obscure corners, the historical diversification benefits will likely fade. Granted, the outlook for expected diversification benefits fluctuates through time, and so what looks unattractive today may look considerably more compelling tomorrow (and vice versa). But as a general proposition, it’s reasonable to assume that correlations generally will inch closer to 1.0. That doesn’t mean that diversifying across asset classes is destined to become worthless, but the expected payoff is likely to dim with the passage of time.

Mathematically, any two items that are not 100% correlated will reduce volatility when combined.  But that doesn’t necessarily mean it’s a good addition to your portfolio—or that modern portfolio theory is a very good way to construct a portfolio.  (We will set aside for now the MPT idea that volatility is necessarily a bad thing.)  The article includes a nice graphic, reproduced below, that shows how highly correlated many asset classes are with the US market, especially if you keep in mind that these are 36-month rolling correlations.  Many asset classes may not reduce portfolio volatility much at all.

Source: The Capital Spectator  (click on image to enlarge)

As Mr. Picerno points out, optimal allocations are far more sensitive to returns than to correlations or volatility.  So even if you find a wonderfully uncorrelated investment, if it has a lousy return it may not help the overall portfolio much.  It would reduce volatility, but quite possibly at a big cost to overall returns.  The biggest determinant of your returns, of course, is what assets you actually hold and when.  The author puts this a slightly different way:

Your investment results also rely heavily on how and when you rebalance the mix.

Indeed they do.  If you hold equities when they are doing well and switch to other assets when equities tail off, your returns will be quite different than an investor holding a static mix.  And your returns will be way different than a scared investor that holds cash when stocks or other assets are doing well.

In other words, the return of your asset mix is what impacts your performance, not correlations or volatility.  This seems obvious, but in the fog of equations about optimal portfolio construction, this simple fact is often overlooked.  Since momentum (relative strength) is generally one of the best-performing and most reliable return factors, that’s what we use to drive our global tactical allocation process.  The idea is to own asset classes as long as they are strong—and to replace them with a stronger asset class when they begin to weaken.  In this context, diversification can be useful for reducing volatility, if you are comfortable with the potential reduction in return that it might entail.  (We  generally advocate diversifying by volatility, by asset class, and by strategy, although the specific portfolio mix might change with the preference of the individual investor.)  If volatility is well-tolerated, maybe the only issue is trying to generate the strongest returns.

Portfolio construction can’t really be reduced to some “optimal” set of tradeoffs.  It’s complicated because correlations change over time, and because investor preferences between return and volatility are in constant flux.  There is nothing stable about the portfolio construction process because none of the variables can be definitively known; it’s always an educated approximation.  Every investor gets to decide—on an ongoing basis—what is truly important: returns (real money you can spend) or volatility (potential emotional turmoil).  I always figure I can afford Maalox with the extra returns, but you can easily see why portfolio management is overwhelming to so many individual investors.  It can be torture.

Portfolio reality, with all of its messy approximations, bears little resemblance to the seeming exactitude of Modern Portfolio Theory.

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Factor Performance and Factor Failure

July 30, 2013

Advisor Perspectives recently carried an article by Michael Nairne of Tacita Capital about factor investing.  The article discussed a number of aspects of factor investing, including factor performance and periods of factor underperformance (factor failure).  The remarkable thing about relative strength (termed momentum in his article) is the nice combination of strong performance and relatively short periods of underperformance that it affords the investor seeking alpha.

Mr. Nairne discusses a variety of factors that have been shown to generate excess returns over time.  He includes a chart showing their performance versus the broad market.

Source: Advisor Perspectives/Tacita Capital  (click on image to enlarge)

Yep, the one at the top is momentum.

All factors, even very successful ones, underperform from time to time.  In fact, the author points out that these periods of underperformance might even contribute to their factor returns.

No one can guarantee that the return premia originating from these dimensions of the market will persist in the future. But, the enduring nature of the underlying causes – cognitive biases hardwired into the human psyche, the impact of social influences and incremental risk – suggests that higher expected returns should be available from these factor-based strategies.

There is another reason to believe that these strategies offer the prospect of future return premia for patient, long-term investors. These premia are very volatile and can disappear or go negative for many years. The chart on the following page highlights the percentage of 36-month rolling periods where  the factor-based portfolios – high quality, momentum, small cap, small cap value and value – underperformed the broad market.

To many investors, three years of under-performance is almost an eternity. Yet, these factor portfolios underperformed the broad market anywhere from almost 15% to over 50% of the 36-month periods from 1982 to 2012. If one were to include the higher transaction costs of the factor-based portfolios due to their higher turnover, the incidence of underperformance would be more  frequent. One of the reasons that these premia will likely persist is that many  investors are simply not patient enough to stay invested to earn them.

The bold is mine, but I think Mr. Nairne has a good point.  Many investors seem to believe in magic and want their portfolio to significantly outperform—all the time.

That’s just not going to happen with any factor.  Not surprisingly, though, momentum has tended to have shorter stretches of underperformance than many other factors, a consideration that might have been partially responsible for its good performance over time.  Mr. Nairne’s excellent graphic on periods of factor failure is reproduced below.

Source: Advisor Perspectives/Tacita Capital (click on image to enlarge)

Once again, whether you choose to try to harvest returns from relative strength or from one of the other factors, patience is an underrated component of actually receiving those returns.  The market can be a discouraging place, but in order to reap good factor performance you have to stay with it during the inevitable periods of factor failure.

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Alternative Beta

July 22, 2013

…has been discovered by the Wall Street Journal.  Recently, they wrote an article about better ways to index—alternative beta—and referenced a study by Cass Business School.  (We wrote about this study here in April.)

Here’s the WSJ’s take on the Cass Business School study:

The Cass Business School researchers examined how 13 alternative index methodologies would have performed for the 1,000 largest U.S. stocks from 1968 to 2011.

All 13 of the alternative indexes produced higher returns than a theoretical market-cap index the researchers created. While the market-cap index generated a 9.4% annualized return over the full period, the other indexes delivered between 9.8% and 11.4%. The market-cap-weighted index was the weakest performer in every decade except the 1990s.

The most interesting part of the article, to me, was the discussion of the growing acceptance of alternative beta.  This is truly exciting.

Indeed, a bevy of funds tracking alternative indexes have been launched in recent years. And their popularity is soaring: 43% of inflows into U.S.-listed equity exchange-traded products in the first five months of 2013 went to products that aren’t weighted by market capitalization, up from 20% for all of last year, according to asset manager BlackRock Inc.

And then there was one mystifying thing: although one of the best-performing alternative beta measures is relative strength (“momentum” to academics), relative strength was not mentioned in the WSJ article at all!

Instead there was significant championing of fundamental indexes.  Fundamental indexes are obviously a valid form of alternative beta, but I am always amazed how relative strength flies under the radar.  (See The #1 Investment Return Factor No One Wants to Talk About.)  Indeed, as you can see from the graphic below, the returns of two representative ETFs, PRF and PDP are virtually indistinguishable.  One can only hope that relative strength will eventually gets its due.

The performance numbers above are pure price returns, based on the applicable index not  inclusive of dividends, fees, commissions, or other expenses. Past performance not indicative of future results.  Potential for profits accompanied by possibility of loss.  See for more information.  

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The Wonders of Momentum

April 18, 2013

Relative strength investors will be glad to know that James Picerno’s Capital Spectator blog has an article on the wonders of momentum.  He discusses the momentum “anomaly” and its history briefly:

Momentum is one of the oldest and most persistent anomalies in the financial literature. The tendency of positive or negative returns to persist for a time seems like a ridiculously simple predictor, but it works. There’s an ongoing debate about why it works, but the results in numerous tests speak loud and clear. Unlike many (most?) reported sources of alpha, the market-beating and risk-lowering results linked to momentum strategies appear to be immune to arbitrage.

Informally, it’s fair to say that investors have been exploiting momentum in various forms for as long as humans have been trading assets. Formally, the concept dates to at least 1937, when Alfred Cowles and Herbert Jones reviewed momentum in their paper “Some A Priori Probabilities in Stock Market Action.” In the 21st century, an inquiring reader can easily find hundreds of papers on the subject, most of it published in the wake of Jegadeesh and Titman’s seminal 1993 work: “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency,” which marks the launch of the modern age of momentum research.

I think his observation that momentum (relative strength to us) has been around since humans have been trading assets is spot on.  It’s important to keep that in mind when thinking about why relative strength works—and why it has been immune to arbitrage.  He writes:

Momentum, it seems, is one of the rare risk factors with features that elude so many other strategies: It’s persistent, conceptually straightforward, robust across asset classes, and relatively easy to implement. It’s hardly a silver bullet, but nothing else is either.

The only mystery: Why are we still talking about this factor in glowing terms? We still don’t have a good answer to explain why this anomaly hasn’t been arbitraged away, or why it’s unlikely to meet an untimely demise anytime soon.

Mr. Picerno raises a couple of important points here.  Relative strength does have a lot of attractive features.  The reason it is not a silver bullet is that it underperforms severely from time to time.  Although that is also true of other strategies, I think the periodic underperformance is one of the reasons why the excess returns have not been arbitraged away.

Although he suggests we don’t have a good answer about why momentum works, I’d like to offer my explanation.  I don’t know if it’s a good answer or not, but it’s what I’ve arrived at after years of research and working with relative strength portfolios—not to mention a degree in psychology and a couple of decades of seeing real investors operate in the market laboratory.

  • Relative strength straddles both fundamental analysis and behavioral finance.
  • High relative strength securities or assets are generally strong because they are undergoing fundamental improvement or are in a sweet spot for fundamentals.  In other words, if oil prices are trending strongly higher, it’s not surprising that certain energy stocks are strong.  That’s to be expected from the fundamentals.  Often there is improvement at the margin, perhaps in revenue growth or operating margin—and that improvement is often underestimated by analysts.  (Research shows that investors are more responsive to changes at the margin than to the absolute level of fundamental factors.  For example, while Apple’s operating margin grew from 2.2% in 2003 to 37.4% in 2012, the stock performed beautifully.  Even though the operating margin is expected to be in the 35% range this year—which is an extremely high level—the stock is getting punished.  Valero’s stock price plummeted when margins went from 10.0% in 2006 to 2.4% in 2009, but has doubled off the low as margins rebounded to 4.8% in 2012.  Apple’s operating margin on an absolute basis is drastically higher than Valero’s, but the delta is going the wrong way.)  High P/E multiples can often be maintained as long as margin improvement continues, and relative strength tends to take advantage of that trend.  Often these trends persist much longer than investors expect.
  • From the behavioral finance side, social proof helps reinforce relative strength.  Investors herd and they gravitate toward what is already in motion, and that reinforces the price movement.  They are attracted to the popular and repelled by the unpopular.
  • Periodic bouts of underperformance help keep the excess returns of relative strength high.  When momentum goes the wrong way it can be ugly.  Perhaps margins begin to contract and financial results are worse than analysts expect.  The security has been rewarded with a high P/E multiple, which now begins to unwind.  The herd of investors begins to stampede away, just as they piled in when things were going well.  Momentum can be volatile and investors hate volatility.  Stretches of underperformance are psychologically painful and the unwillingness to bear pain (or appropriately manage risk) discourages investors from arbitraging the excess returns away.

In short, I think there are multiple reasons why relative strength works and why it is difficult to arbitrage away the excess returns.  Those reasons are both fundamental and behavioral and I suspect will defy easy categorization.  Judging from my morning newspaper, human nature doesn’t change much.  Until it does, markets are likely to work the same way they always have—and relative strength is likely to continue to be a powerful return factor.

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Quote of the Week

February 12, 2013

To attain knowledge, add things every day. To attain wisdom, subtract things every day.—-Lao-Tzu

There are many theories about investing in the market.  Some are simple, while others are mind-numbingly complex.  Relative strength is one of the simple methods.  Because it is simple, it is robust and much more difficult to break than a multi-factor method that relies on many relationships between factors.  Complicated things are fragile and tend to break easily.  That’s not to say that relative strength is perfect—it will underperform periodically like every other method.  But relative strength subtracts everything except price, and asserts that strong price action is typically a precursor of good relative performance.  History bears that out.

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Relative Strength: A Solid Investment Method

January 28, 2013

We are fond of relative strength.  It’s a solid investment method that have proven itself over a long period of time.  Sure, it has its challenges and there are certainly periods of time during which it underperforms, but all-in-all it works and it’s been good to us.  It’s always nice, though, when I run across another credible source that sings its praises.  Consider the following excerpt from an article on the Optimal Momentum blog:

Momentum, on the other hand, has always made sense. It is based on the phrase “cut your losses; let your profits run on,” coined by the famed economist David Ricardo in the 1700s. Ricardo became wealthy following his own advice.  [Editor’s note: We wrote about this in David Ricardo’s Golden Rules.] Many others, such as Livermore, Gartley, Wycoff, Darvas, and Driehaus, have done likewise over the following years. Behavioral finance has given solid reasons why momentum works. The case for momentum is now so strong that two of the fathers of modern finance, Fama and French, call momentum “the premier market anomaly” that is “above suspicion.”

Momentum, on the other hand, is pretty simple. Every approach, including momentum, must determine what assets to use and when to rebalance a portfolio. The single parameter unique to momentum is the look back period for determining an asset’s relative strength. In a 1937, using data from 1920 through 1935, Cowles and Jones found stocks that performed best over the past twelve months continued to perform best afterwards. In 1967, Bob Levy came to the same conclusion using a six-month look back window applied to stocks from 1960 through 1965. In 1993, using data from 1962 through 1989 and rigorous testing methods, Jegadeesh and Titman (J&T) reaffirmed the validity of momentum. They found the same six and twelve months look back periods to be best. Momentum is not only simple, but it has been remarkably consistent over the past seventy-five years.

Momentum, on the other hand, is one of the most robust approaches in terms of its applicability and reliability. Following the 1993 seminal study by J&T, there have been nearly 400 published momentum papers, making it one of the most heavily researched finance topics over the past twenty years. Extensive academic research has shown that price momentum works in virtually all markets and time periods, from Victorian ages up to the present.

Of course, momentum is just the academic term for relative strength.  For more on the history of relative strength—and how it became known as momentum in academia—see CSI Pasadena: Relative Strength Identity Theft.  The bigger point is that relative strength has a lot of backing from both academics and practitioners.  There are more complicated investment methods, but not many that are better than relative strength.

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Fama and French Love Relative Strength?

December 17, 2012

Although relative strength investors are not always happy about having their return factor co-opted by academics (who re-named it “momentum”), it’s always nice to see that academics love the power of momentum.  In their 2007 paper, Dissecting Anomalies, Eugene Fama and Ken French cover the waterfront on return anomalies, examining them both through style sorts and regression analysis.  CXO Advisory put together a very convenient summary of their findings, reproduced below.

Source: CXO Advisory  (click to enlarge)

CXO’s conclusion is especially succinct: In summary, some anomalies are stronger and more consistent than  others.    Momentum appears to be the strongest and most consistent.

We couldn’t have said it better ourselves.

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Advisors Turning to ETFs

September 12, 2012

Most professionals have noticed the move to ETFs happening, but a recent article at AdvisorOne makes the magnitude of the shift more clear:

Since the beginning of 2012, investors have pulled almost $15 billion from U.S. stock funds, while boosting money put into ETFs by $16 billion, according to industry studies.

In the latest AdvisorBenchmarking report, for example, 54% of advisors say they are likely to increase their use of the ETFs in the near future, with 43% saying they expect their use of ETFs over the next three years to remain the same.

What is the strategic role of ETFs in portfolios? According to the survey, many strategies lie behind ETF implementation. While “core” and “sector” exposures were most common, several other approaches were all within a few points of each other, including: alternatives exposure, directional market positions, factor or asset class exposures and country/region exposure. Clearly, ETFs are providing advisors and investors with attractive options for expressing their views, and that is translating into strong, consistent growth for these vehicles.

AdvisorBenchmarking provided a nice graphic on the strategic uses of ETFs.  It’s clear that ETFs are multipurpose vehicles because advisors are using them to meet a lot of different objectives!

Source: AdvisorBenchmarking/AdvisorOne (click on image to enlarge)

According to their survey, only 8% of ETF use is coming from directional market positions—far less than imagined by people who criticize ETF investors as reckless market timers.  For the most part, advisors are using ETFs to get exposures that were unavailable before, whether it is to a specific sector, country, or asset class.

Most of the ETFs now available offer passive exposures to various indexes.  More interesting to me are the small number of semi-active ETFs that are designed to provide factor exposure in an attempt to generate alpha.  Research suggests that combining factor exposures might be a superior way to capture market returns.

The Technical Leaders indexes are constructed to provide exposure to the momentum (relative strength) factor and there are a couple of low-volatility ETFs around as well.  There are a few ETFs explicitly designed for value exposure, although I don’t think this area has been well-exploited yet.  (I’m sorry to see Russell close down their suite of ETFs, which I thought had a lot of promise.)

With more and more options available to advisors, I would not be surprised to see ETF use continue to surge.

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The Rationale For Momentum

August 15, 2012

How do you judge the merits of momentum?  Gary Antonacci says there are three ways to evaluate any investment opportunity:

  1. The first is to require that the method make sense. Is it in tune with the nature of the markets?
  2. The second criterion for accepting a new investment approach is robustness.
  3. The final way of judging robustness is by seeing how well an approach holds up in multiple markets and time periods, as well as with different parameter values.

The whole article is worth the read, but on the subject of robustness, Antonacci states the following:

Momentum is one of the most robust approaches ever explored in terms of its applicability and reliability. Following the 1993 seminal study by Jegadeesh and Titman, there have been nearly 400 published momentum papers, making it one of the most heavily researched finance topics over the past twenty years. Extensive research has shown that price momentum works in virtually all markets and all times periods from Victorian ages up to the present. It also has performed well using a wide range of look back periods.

There will always be doubters and those too impatient to capitalize, but the data supporting momentum is pretty hard to refute.

Note: Longtime readers will recognize that relative strength is known as “momentum” in the academic community.

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From the Archives: Is Buy-and-Hold Dead?

June 20, 2012

The  Journal of Indexes has the entire current issue devoted to articles on this topic, along with the best magazine cover ever.  (Since it is, after all, the Journal of Indexes, you can probably guess how they came out on the active versus passive debate!)

One article by Craig Israelson, a finance professor at Brigham Young University, stood out.  He discussed what he called “actively passive” portfolios, where a number of passive indexes are managed in an active way.  (Both of the mutual funds that we sub-advise and our Global Macro separate account are essentially done this way, as we are using ETFs as the investment vehicles.)  With a mix of seven asset classes, he looks at a variety of scenarios for being actively passive: perfectly good timing, perfectly poor timing, average timing, random timing, momentum, mean reversion, buying laggards, and annual rebalancing with various portfolio blends.  I’ve clipped one of the tables from the paper below so that you can see the various outcomes:

 Is Buy and Hold Dead?

Click to enlarge

Although there is only a slight mention of it in the article, the momentum portfolio (you would know it as relative strength) swamps everything but perfect market timing, with a terminal value more than 3X the next best strategy.  Obviously, when it is well-executed, a relative strength strategy can add a lot of return.  (The rebalancing also seemed to help a little bit over time and reduced the volatility.)

Maybe for Joe Retail Investor, who can’t control his emotions and/or his impulsive trading, asset allocation and rebalancing is the way to go, but if you have any kind of reasonable systematic process and you are after returns, the data show pretty clearly that relative strength should be the preferred strategy.

—-this article originally appeared 1/8/2010.  Relative strength rocks.

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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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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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