Investment Process versus Investment Performance

September 6, 2013

Marshall Jaffe wrote an excellent article on investment process versus investment performance in the most recent edition of ThinkAdvisor. I think it is notable for a couple of reasons. First, it’s pithy and well-written. But more importantly, he’s very blunt about the problems of focusing only on investment performance for both clients and the industry. And make no mistake—that’s how the investment industry works in real life, even though it is a demonstrably poor way to do things. Consider this excerpt:

We see the disclaimer way too often. “Past performance is no guarantee of future results.” It is massively over-used—plastered on countless investment reports, statements and research. It’s not simply meaningless; it’s as if it’s not even there. And that creates a huge problem, because the message itself is really true: Past performance has no predictive value.

Since we are looking for something that does have predictive value—all the research, experience and hard facts say: Look elsewhere.

This is not a controversial finding. There are no fringe groups of investors or scholars penning op-ed pieces in the Wall Street Journal shooting holes in the logic of this reality. Each year there is more data, and each year that data reconfirms that past performance is completely unreliable as an investment tool. Given all that, you would think it would be next to impossible to find any serious investors still using past performance as a guideline. Indeed, that would be a logical conclusion.

But logical conclusions are often wrong when it comes to understanding human behavior. Not only does past performance remain an important issue in the minds of investors, for the vast majority it is the primary issue. In a study I referred to in my August column, 80% of the hiring decisions of large and sophisticated institutional pension plans were the direct result of outstanding past performance, especially recent performance.

The truth hurts! The bulk of the article discusses why investors focus on performance to their detriment and gives lots of examples of top performers that focus only on process. There is a reason that top performers focus on process—because results are the byproduct of the process, not an end in themselves.

The reason Nick Saban, our best athletes, leading scientists, creative educators, and successful investors focus on process is because it anchors them in reality and helps them make sensible choices—especially in challenging times. Without that anchor any investor observing the investment world today would be intimidated by its complexity, uncomfortable with its volatility and (after the meltdown in 2008) visibly fearful of its fragility. Of course we all want good returns—but those who use a healthy process realize that performance is not a goal; performance is a result.

Near the end of the article, I think Mr. Jaffe strikes right to the core of the investment problem for both individual investors and institutions. He frames the right question. Without the right question, you’re never going to get the right answer!

In an obsessive but fruitless drive for performance too many fund managers compromise the single most important weapon in their arsenal: their investment process.

Now we can see the flaw in the argument that an investor’s basic choice is active or passive. An investor indeed has two choices: whether to be goal oriented or process oriented. In reframing the investment challenge that way, the answer is self-evident and the only decision is whether to favor a mechanical process or a human one.

Reframing the question as “What is your investment process?” sidelines everything else. (I added the bold.) In truth, process is what matters most. Every shred of research points out the primacy of investment process, but it is still hard to get investors to look away from performance, even temporarily.

We focus on relative strength as a return factor—and we use a systematic process to extract whatever return is available—but it really doesn’t matter what return factor you use. Value investors, growth investors, or firms trying to harvest more exotic return factors must still have the same focus on investment process to be successful.

If you are an advisor, you should be able to clearly explain your investment process to a client. If you are an investor, you should be asking your advisor to explain their process to you. If there’s no consistent process, you might want to read Mr. Jaffe’s article again.

HT to Abnormal Returns

Leave a Comment » | From the MM, Investor Behavior, Markets, Thought Process | Tagged: , , , , | Permalink

Posted by:

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.

Leave a Comment » | Investor Behavior, Markets, Relative Strength Research, Thought Process | Tagged: , , , , | Permalink

Posted by:

Investment Manager Selection

April 12, 2013

Investment manager selection is one of several challenges that an investor faces. However, if manager selection is done well, an investor has only to sit patiently and let the manager’s process work—not that sitting patiently is necessarily easy! If manager selection is done poorly, performance is likely to be disappointing.

For some guidance on investment manager selection, let’s turn to a recent article in Advisor Perspectives by C. Thomas Howard of AthenaInvest. AthenaInvest has developed a statistically validated method to forecast fund performance. You can (and should) read the whole article for details, but good investment manager selection boils down to:

  • investment strategy
  • strategy consistency
  • strategy conviction

This particular article doesn’t dwell on investment strategy, but obviously the investment strategy has to be sound. Relative strength would certainly qualify based on historical research, as would a variety of other return factors. (We particularly like low-volatility and deep value, as they combine well with relative strength in a portfolio context.)

Strategy consistency is just what it says—the manager pursues their chosen strategy without deviation. You don’t want your value manager piling into growth stocks because they are in a performance trough for value stocks (see Exhibit 1999-2000). Whatever their chosen strategy or return factor is, you want the manager to devote all their resources and expertise to it. As an example, every one of our portfolio strategies is based on relative strength. At a different shop, they might be focused on low-volatility or small-cap growth or value, but the lesson is the same—managers that pursue their strategy with single-minded consistency do better.

Strategy conviction is somewhat related to active share. In general, investment managers that are willing to run relatively concentrated portfolios do better. If there are 250 names in your portfolio, you might be running a closet index fund. (Our separate accounts, for example, typically have 20-25 positions.) A widely dispersed portfolio doesn’t show a lot of conviction in your chosen strategy. Of course, the more concentrated your portfolio, the more it will deviate from the market. For managers, career risk is one of the costs of strategy conviction. For investors, concentrated portfolios require patience and conviction too. There will be a lot of deviation from the market, and it won’t always be positive. Investors should take care to select an investment manager that uses a strategy the investor really believes in.

AthenaInvest actually rates mutual funds based on their strategy consistency and conviction, and the statistical results are striking:

The higher the DR [Diamond Rating], the more likely it will outperform in the future. The superior performance of higher rated funds is evident in Table 1. DR5 funds outperform DR1 funds by more than 5% annually, based on one-year subsequent returns, and they continue to deliver outperformance up to five years after the initial rating was assigned. In this fashion, DR1 and DR2 funds underperform the market, DR3 funds perform at the market, and DR4 and DR5 funds outperform. The average fund matches market performance over the entire time period, consistent with results reported by Bollen and Busse (2004), Brown and Goetzmann (1995) and Fama and French (2010), among others.

Thus, strategy consistency and conviction are predictive of future fund performance for up to five years after the rating is assigned.

The bold is mine, as I find this remarkable!

I’ve reproduced a table from the article below. You can see that the magnitude of the outperformance is nothing to sniff at—400 to 500 basis points annually over a multi-year period.

diamondratings zps3970f53e Investment Manager Selection

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

The indexing crowd is always indignant at this point, often shouting their mantra that “active managers don’t outperform!” I regret to inform them that their mantra is false, because it is incomplete. What they mean to say, if they are interested in accuracy, is that “in aggregate, active managers don’t outperform.” That much is true. But that doesn’t mean you can’t locate active managers with a high likelihood of outperformance, because, in fact, Tom Howard just demonstrated one way to do it. The “active managers don’t outperform” meme is based on a flawed experimental design. I tried to make this clear in another blog post with an analogy:

Although I am still 6’5″, I can no longer dunk a basketball like I could in college. I imagine that if I ran a sample of 10,000 random Americans and measured how close they could get to the rim, very few of them could dunk a basketball either. If I created a distribution of jumping ability, would I conclude that, because I had a large sample size, the 300 people would could dunk were just lucky? Since I know that dunking a basketball consistently is possible–just as Fama and French know that consistent outperformance is possible–does that really make any sense? If I want to increase my odds of finding a portfolio of people who could dunk, wouldn’t it make more sense to expose my portfolio to dunking-related factors–like, say, only recruiting people who were 18 to 25 years old and 6’8″ or taller?

In other words, if you look for the right characteristics, you have a shot at finding winning investment managers too. This is valuable information. Think of how investment manager selection is typically done: “What was your return last year, last three years, last five years, etc.?” (I know some readers are already squawking, but the research literature shows clearly that flows follow returns pretty closely. Most “rigorous due diligence” processes are a sham—and, unfortunately, research shows that trailing returns alone are not predictive.) Instead of focusing on trailing returns, investors would do better to locate robust strategies and then evaluate managers on their level of consistency and conviction.

Leave a Comment » | From the MM, Portfolio Theory, Thought Process | Tagged: , , , , | Permalink

Posted by:

Smart Beta vs. Monkey Beta

April 9, 2013

Andy wrote a recent article entitled Smart Beta Gains Momentum. It’s gaining momentum for a good reason! A recent study at Cass Business School in London found that cap-weighting was not a very good way to construct an index. Lots of methods to get exposure to smart beta do better. The results were discussed in an article at Index Universe. Some excerpts:

Researchers have found that equity indices constructed randomly by ‘monkeys’ would produce higher risk-adjusted returns than an equivalent market capitalisation-weighted index over the last 40 years…

The findings come from a recent study by Cass Business School (CBS), which was based on monthly US share data from 1968 to 2011. The authors of the study found that a variety of alternative index weighting schemes all delivered superior returns to the market cap approach.

According to Dr. Nick Motson of CBS, co-author of the study, “all of the 13 alternative indices we studied produced better risk-adjusted returns than a passive exposure to a market-cap weighted index.”

The study included an experiment that saw a computer randomly pick and weight each of the 1,000 stocks in the sample. The process was then repeated 10 million times over each of the 43 years. Clare describes this as “effectively simulating the stock-picking abilities of a monkey”.

…perhaps most shockingly, we found that nearly every one of the 10 million monkey fund managers beat the performance of the market cap-weighted index,” said Clare.

The findings will be a boost to investors already looking at alternative indexing. Last year a number of European pension funds started reviewing their passive investment strategies, switching from capitalisation-weighting to alternative index methodologies.

Relative strength is one of the prominent smart beta methodologies. Of course, cap-weighting has its uses—the turnover is low and rebalancing is minimized. But purely in terms of performance, the researchers at Cass found that there are better ways to do things. Now that ETFs have given investors a way to implement some of these smart beta methods in a tax-efficient, low-cost manner, I suspect we will see more movement toward smart beta in the future.

1 Comment | Portfolio Theory, Thought Process | Tagged: , , , , , , | Permalink

Posted by:

Emerging Markets ETFs

March 21, 2013

Morningstar came out with a piece yesterday titled Are There Better Emerging-Markets ETF Choices? The article discussed the availability of alternative beta funds in the area, and had this to say, in part, about momentum:

While there has been relatively little academic research done on momentum in emerging-markets stocks, it has been observed in this asset class. There is currently one ETF that looks to capitalize on momentum in emerging-markets stocks-PowerShares DWA Emerging Markets (PIE), which was launched in December 2007. Over the five year period ending Feb. 28, 2013, this fund’s benchmark index produced annualized returns that outstripped the MSCI Emerging Markets Index by 155 basis points while exhibiting fairly similar levels of volatility.

Risk-tolerant investors looking for more growth-oriented exposure to emerging markets may want to consider PIE; it is currently the only emerging-markets ETF of reasonable size to provide a growth tilt.

The article also discusses some of the funds that offer low-volatility exposure, but did not mention that the low-vol and high relative strength return factors often complement one another nicely. In the domestic market, we’ve seen that these factors have excess returns that are negatively correlated. Although usage of low volatility in emerging markets has a much shorter history, it’s possible that we’ll see the same thing there over time.

It’s nice to see Morningstar give relative strength some attention!

PIE2 Emerging Markets ETFs

Source: Yahoo! Finance

See www.powershares.com for more information. Past performance is no guarantee of future returns.

Leave a Comment » | Markets, Relative Strength Research | Tagged: , , , , , , | Permalink

Posted by:

Keeping It Simple in the New Year

January 3, 2013

Barry Ritholtz at The Big Picture has some musings about portfolios for the New Year. I think he’s right about keeping it simple—but I also think his thought is incomplete. He writes:

May I suggest taking control of your portfolio as a worthwhile goal this year?

I have been thinking about this for awhile now. Last year (heh), I read a quote I really liked from Tadas Viskanta of Abnormal Returns. He was discussing the disadvantages of complexity when creating an investment plan:

“A simple, albeit less than optimal, investment strategy that is easily followed trumps one that will abandoned at the first sign of under-performance.”

I am always mindful that brilliant, complex strategies more often than not fail. Why? A simple inability of the Humans running them to stay with them whenever there are rising fear levels (typically manifested as higher volatility and occasional drawdowns).

Let me state this more simply: Any strategy that fails to recognize the psychological foibles and quirks of its users has a much higher probability of failure than one that anticipates and adjusts for that psychology.

Let me just say that there is a lot of merit to keeping things simple. It’s absolutely true that complex things break more easily than simple things, whether you’re talking about kid’s Christmas toys or investor portfolios. I believe in simplicity over complexity.

However, complexity is only the tip of the iceberg that is human nature. Mr. Ritholtz hints at it when he mentions human inability to stay with a strategy when fear comes into the picture. That is really the core issue, not complexity. Adjust for foibles all you want; many investors will still find a way to express their quirks. You can have an obscenely simple strategy, but most investors will still be unable to stay with it when they are fearful.

Trust me, human nature can foil any strategy.

Perhaps a simple strategy will be more resilient than a complex one, but I think it’s most important to work on our resilience as investors.

Tuning out news and pundits is a good start. Delving deeply into the philosophy and inner workings of your chosen strategy is critical too. Understand when it will do well and when it will do poorly. The better you understand your return factor, whether it is relative strength, value, or something else, the less likely you are to abandon it at the wrong time. Consider tying yourself to the mast like Ulysses—make it difficult or inconvenient to make portfolio strategy changes. Maybe use an outside manager in Borneo that you can only contact once per year by mail. I tell clients just to read the sports pages and skip the financial section. (What could be more compelling soap opera than the Jet’s season?) Whether you choose distraction, inconvenience, or steely resolve as your method, the goal is to prevent volatility and the attendant fear it causes from getting you to change course.

The best gift an investor has is self-discipline. As one of our senior portfolio managers likes to point out, “To the disciplined go the spoils.”

2 Comments | Investor Behavior, Markets, Thought Process | Tagged: , , , , , , , , | Permalink

Posted by:

One-Trick Pony

June 12, 2012

Crosshairs Trader has an excerpt from Jack Schwager’s Hedge Fund Market Wizards. The interview with Steve Clark makes an interesting point.

Schwager: You have seen a lot of traders. What are the characteristics of traders who succeed?

Clark: They all work hard. Nearly all the successful traders I know are one-trick ponies. They do one thing, and they do it very well.

I find it interesting that most successful traders specialize in one method or return factor. The takeaway is that it is almost impossible to be an expert at everything.

Although I wouldn’t rule out expanding our expertise at some point, relative strength has always been our focus. It’s an incredible bonus that relative strength is so adaptive that it can be used in many different systematic processes.

(By the way, you’re missing a treat if you haven’t read any of Jack Schwager’s books. I haven’t read the most recent one yet, but his first Market Wizards book is one of my all-time favorites.)

onetrickpony One Trick Pony

One-Trick Pony

Source: dgdesignnetwork (click on image to enlarge)

HT to Abnormal Returns

Leave a Comment » | Thought Process | Tagged: , , , | Permalink

Posted by:

Combining Relative Strength and Low Volatility

October 12, 2011

The power of relative strength as a return factor has been well documented and that evidence is the reason that relative strength drives all of our investment strategies. However, just because it is a winning return factor over time doesn’t mean that anyone should or will construct an asset allocation composed entirely of relative strength-based strategies. Financial advisors who are in a position to decide which strategies to include in an asset allocation must then decide how to find complementary return factors. We have previously written about the benefits of combining relative strength and value, for example.

However, it appears that value is not the only suitable complement for relative strength strategies. Another option would be to consider combining the recently introducted PowerShares S&P Low Volatility Portfolio (SPLV) with our own PowerShares DWA Techical Leaders Portfolio (PDP).

A description of each is as follows:

The PowerShares DWA Technical Leaders Portfolio (PDP) is based on the Dorsey Wright Technical Leaders™ Index (Index). The Fund will normally invest at least 90% of its total assets in securities that comprise the Index and ADRs based on the securities in the Index. The Index includes approximately 100 U.S.-listed companies that demonstrate powerful relative strength characteristics. The Index is constructed pursuant to Dorsey Wright proprietary methodology, which takes into account, among other factors, the performance of each of the 3,000 largest U.S.-listed companies as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors. The Index is reconstituted and rebalanced quarterly using the same methodology described above.

The PowerShares S&P 500® Low Volatility Portfolio (SPLV) is based on the S&P 500® Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor’s and consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

The efficient frontier below points out that combining the two can be an effective way to reduce the volatility and/or increase the return over using PDP or SPLV independently.

pdpsplv2 Combining Relative Strength and Low Volatility

(Click to enlarge)

The table below is also for the period April 1997-September 2011. (The hypothetical returns for PDP only go back to April 1997.)

pdp3 Combining Relative Strength and Low Volatility

Perhaps most interesting to asset allocators is the fact that the correlation of excess returns of PDP and SPLV over this time period was -0.29. The goal of asset allocation is to not only add value, but to also construct an allocation that clients will stay with for the long-run. Rather than whip in and out of PDP, perhaps a more enlightened approach is to buy and hold positions in both PDP and SPLV for a portion of the allocation.

For the time periods when hypothetical returns were used, the returns are that of the PowerShares Dorsey Wright Technical Leaders Index and of the S&P 500 Low Volatility Index. The hypothetical returns have been developed and tested by the Manager (Dorsey Wright in the case of PDP and Standard & Poors in the case of SPLV), but have not been verified by any third party and are unaudited. The performance information is based on data supplied by the Dorsey Wright or from statistical services, reports, or other sources which Dorsey Wright believes are reliable. The performance of the Indexes, prior to the inception of actual management, was achieved by means of retroactive application of a model designed with hindsight. For the hypothetical portfolios, returns do not represent actual trading or reflect the impact that material economic and market factors might have had on the Manager’s decision-making under actual circumstances. Actual performance of PDP began March 1, 2007 and actual performance of SPLV began May 5, 2011. See PowerShares.com for more information.

2 Comments | Relative Strength Research | Tagged: , , , , , | Permalink

Posted by:

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:

index3 The #1 Investment Return Factor No One Wants to Talk About

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.

index2 The #1 Investment Return Factor No One Wants to Talk About

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 www.powershares.com 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.

7 Comments | From the MM, Markets, Relative Strength Research, Thought Process | Tagged: , , | Permalink

Posted by: