Complementary Strategies: One Key to Diversification

October 18, 2012

We use relative strength (known as “momentum” to academics) in our investment process. We’ve written extensively how complementary strategies like low volatility and value can be used alongside relative strength in a portfolio. S&P is now on board the train, as they show in this research paper how alternative beta strategies are often negatively correlated. In fact, here’s the correlation matrix from the paper:

Altbetacorrelation Complementary Strategies: One Key to Diversification

Source: Standard & Poors (click to enlarge image)

You can see that relative strength/momentum is negatively correlated with both value and low volatility. This is why we prefer diversification through complementary strategies.

They conclude:

…combining alternative beta strategies that are driven by distinct sets of risk factors may help to reduce the active risk and improve the information ratio.

Diversification is important for portfolios, but it’s not easily achieved. For example, if you decide to segment the market by style box rather than by return factors, you will find that the style boxes are all fairly correlated. Although it’s a mathematical truism that anything that isn’t 100% correlated will help diversification, diversification is far more efficient when correlations are low or negative.

We think using factor returns to identify complementary strategies is one of the more effective keys to diversification.

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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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PDP vs. Ken French High Relative Strength

June 12, 2012

In past posts (“Relative Strength vs. Value-Performance over Time” and “Relative Strength, Decade by Decade”), I’ve used the Ken French database’s relative strength portfolio. While this is useful in concept, what solidifies the findings in my previous posts is the similarity between Ken French’s High RS data and one of our ETFs, PDP.

PDP is a PowerShares ETF based on the Dorsey Wright Technical Leaders Index. It has its own proprietary calculation method, which is different than that of the Ken French database. Yet, over the past five years, both have performed very similarly.

Table 1:

HighRSPDPSP500 PDP vs. Ken French High Relative Strength

PDP has only been on the market since March of 2007. Yet, over those five years, the two indexes have performed almost exactly the same…no small feat considering the stock market over the last few years. Imagine, then, using the Ken French data as a “loose proxy” for PDP going back decades. We’re not saying the two will always perform the same—we’re just pointing out that it’s clear both indexes are exploiting the same factor (RS) in a practical way.

Currently, relative strength growth rates (10-year rolling returns) are at some of the lowest levels since the 1930s; and historically we can see that growth rates often increase once they hit rock bottom. That may bode well for relative strength returns going forward.

Chart 1:

HighRS10YearGrowthRatesBar PDP vs. Ken French High Relative Strength

See www.powershares.com for more information about PDP. Past performance is no guarantee of future returns. A list of all holdings for the trailing 12 months is available upon request.

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Relative Strength Still Off the Radar

May 16, 2012

The Big Picture has a thumbnail summary of the annual Merrill Lynch US Equity and US Quant Strategy pieces, where they interview 100 large institutional managers. Of particular interest to me was the top ten return factors by popularity.

factorpopularity Relative Strength Still Off the Radar

via The Big Picture (click on image to enlarge)

You can see that relative strength did not crack the top ten. On the bigger chart, which you can see in the article, relative strength came in at #11. Of course, there are many formulations of relative strength, so even that ranking probably covers a lot of different methods.

A number of the popular factors are value-related and some are based on profitability. All of these factors ultimately interact in complicated ways, but you don’t have to worry about a crowded trade in relative strength.

Value, quality, and risk-related factors are all much more popular than relative strength.

stylepopularity Relative Strength Still Off the Radar

via The Big Picture (click on image to enlarge)

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