How to Find the Winners

February 2, 2010

Martjin Cremers, a professor at Yale, and his colleague, Antti Petajisto, authored a paper on the concept of active share. Advisor Perspectives recently interviewed Mr. Cremers to ask about his research. (This link is worth checking out, as it has links to additional articles such as From Yale University: New Research Confirms the Value of Active Management and Compelling Evidence That Active Management Really Works.)

Active share is a holdings-based measure of how different the holdings in an active portfolio are from the benchmark portfolio. As an example, an S&P 500 index fund would have an active share of 0%, since the holdings would be identical to the benchmark. Portfolios with low active shares around 30% are still so close to the benchmark that they are considered closet indexers.

Where Cremers and Petajisto differ from the establishment is that by segmenting managers in this way, they believe they are able to identify a subset of managers-those with high active share-who can outperform the benchmark over time.

That result is probably the most controversial. We find significant evidence, in our view, that a lot of managers actually do have some skill.

What I find refreshing about their approach is their willingness to examine aggregate data more thoroughly. In aggregate, their data also shows that fund managers do not outperform the benchmark. Most studies stop there, pretend not to notice that numerous tested factors show evidence of long-term outperformance, and then advise investors to buy index funds and to forget about active management.

Cremers and Petajisto were not content to take the lazy road. And, in fact, when looked at in more granular fashion, the data tells a different story. Closet indexers do worse than the market, but many managers with high active share show evidence of skill. This is much more in accord with other academic research that shows that broad, robust factors like relative strength and deep value can outperform over time. A manager that pursued such a strategy would have high active share and would have a good chance of long-term outperformance. That’s exactly what our systematic relative strength strategies are designed to do.

2 Comments | Markets, Relative Strength Research, Thought Process | Permalink
Posted by Mike Moody

Retirement Income

February 2, 2010

As baby boomers age, retirement income has become a hot topic. Most of the discussions revolve around determining the best way to structure a retirement portfolio to generate the maximum income from it. I know of no studies that specifically address this issue from a quantitative standpoint, but from a psychological perspective, the idea of dividing assets into buckets has been gaining favor. In this transcript from Consuelo Mack’s Wealthtrack program, several financial experts discuss retirement income ideas and I note that the buckets idea is mentioned frequently.

Although holding up to five years worth of spending in cash is not likely to optimize the overall portfolio return, the idea of buckets is designed to allow investors to hold growth assets with less fear. Spending comes from the liquidity bucket, which given the mind’s natural tendency to segment things, does not seem as connected to the growth part of the portfolio as when the assets are combined in one large portfolio. The investor may have a tendency to leave the growth bucket alone, perhaps using occasional gains to replenish the liquidity bucket.

The additional psychological advantage of separating the liquidity and growth buckets is that investors may not feel pressure to liquidate when the market is weak. If they feel that their spending needs for the immediate future are covered, they may be more willing to let the growth investments fluctuate-and not sell out at inopportune times. If using the bucket approach leads to better investor behavior in the long run, I’m all for it.

Leave a Comment » | Investor Behavior, Retirement/Saving | Permalink
Posted by Mike Moody

Politics 101

February 2, 2010

Last week I read something in the WSJ that made my head spin.

A bill was voted down in the Senate which would have created a bipartisan commission whose job would be to tackle the enormous budget deficit the United States is currently running. The key words here are bipartisan commission. This article, taken from the Lawrence Journal, sums up a few of the constraints the commission would have had, which would have kept either party from gaining unchecked authority in balancing the US budget.

The failed bill wasn’t a mandate on how to solve the deficit; it was a bill about setting up a framework of discussion for solving the deficit. There’s a difference between the two, and the bill would have allowed many paths to a solution.

The deficit clearly needs to be addressed before the U.S. ends up with a forced fiscal austerity program like Greece. If you want to get a sense for how rapidly our public debt is growing, here’s a website devoted to tallying our nation’s debt: Debt Clock. (Be sure to hit Refresh a couple times to get a sense of the pace.) It’s scary and breathtaking.

Anyway, back to the bill voted down in the Senate. Apparently, six Senators co-sponsored the writing of the bill, put their name on the bill, and then voted “No” during the roll-call. It might help to repeat the sentence a few times to appreciate the full effect. The behavior of our elected officials is quite discouraging. How can anyone justify even one second of the time these six Senators spent working on this bill, only to vote against it during the roll call? What is the point? I don’t think there is an easy answer to the deficit problem, but it doesn’t seem like voting against your own bill is part of the solution!

To solve a problem, it seems necessary to first identify the problem’s cause. If your books are deeply in the red, you must either cut costs, sell assets, or raise revenues. None of the options is an easy way out; eventually, somebody will have to foot the bill. It’s not going to be a pleasant process for anybody, but maybe things would be more efficient if our government learned to collaborate a little more effectively.

Leave a Comment » | Non-partisan op-ed | Permalink
Posted by JP Lee

Relative Strength Spread

February 2, 2010

The chart below is the spread between the relative strength leaders and relative strength laggards (universe of mid and large cap stocks). When the chart is rising, relative strength leaders are performing better than relative strength laggards. As of 2/1/2010:

As with all strategies, certain environments are more favorable than others for relative strength. We’ve seen a little of everything over the last three years. The RS Spread enjoyed a fairly stable trend higher in 2007. From July of 2008 to March of 2009 the RS Spread gyrated between very favorable and very unfavorable environments. From March 2009 to to May 2009 the RS Spread plunged as the laggards rocketed higher. Since then, the RS Spread has languished.

What comes next? The historical precedent is for a period of a declining RS Spread to transition into a much more favorable environment for relative strength. Time will tell how soon this transition takes place.

Leave a Comment » | Markets | Permalink
Posted by Andy Hyer