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Relative Strength

This the first in a series of articles to help readers understand some basic concepts in today’s financial environment and to explore tactical approaches to improving your investment returns without risking significant loss of capital.

“Alpha” is defined as a measure of portfolio performance on a risk-adjusted basis. It is a term commonly used as a benchmark to compare portfolio returns relative to the S&P500. The goal of this series is to help readers build an Alpha beating portfolio and achieve a steady and reliable income stream from their capital, whether professionally managed or self-directed.

This month: Relative Strength.

Many investors are familiar with the concept of Relative Strength (RS) market strategies, which are based on the idea of identifying and owning only the strongest performing stocks or funds. Such strategies are often called Rotation or Momentum — but they are all related, no matter what the name.

This two-part article first provides an overview of the RS method, and, in the second part, explores why Tactical Asset Management (TAM) may be a superior approach for long-term investors wishing to minimize portfolio volatility. The concept behind RS strategies is as old as Isaac Newton’s falling apple: “A Body in Motion Tends to Remain in Motion” and much research indicates that once stocks and funds begin to move in a certain direction, whether up or down, they often continue in that direction for a period of time.

RS trading attempts to capitalize on this effect by simply identifying which securities demonstrate the strongest momentum on a comparative basis, and then riding these successive momentum “waves” to maximize wealth accumulation and deliver superior Alpha during a given period of time. A variation of this model simply rotates out of former winners and into newer ones as prior momentum fades and new opportunities arise. As well-known market commentator, Jim Cramer, says, “There’s always a bull market somewhere.” The obvious question is: why does this effect exist at all?

In the last century a Nobel Prize was awarded to two researchers who identified momentum as an “unexplainable” aspect of market behavior but, in fact, there are several factors contributing to price momentum, and many are tied to the foibles of human nature itself. Here are a few:

1. Herding Behavior – Investors naturally flock to the stocks and areas of the market that are most covered by the media and discussed by their friends and family.

2. Confirmation Bias and Attraction to Rising Prices – When investors select a stock, whatever the reason, once they see it rise, they are comfortable with holding onto that position or even committing more resources to it based solely on that early success.

3. Business Cycles – The economy naturally follows long-term macro-economic and news-driven cycles. The durability of these cycles supports extended movement by those certain stocks and sectors that are most benefited by any given cycle.

4. Staged Participation – As the various effects above play out over time, the move attracts different types of investors, working its way up the ladder from short-term day-traders covering their short positions, to so-called “swing-traders” placing intermediate trades, to large money managers making longer-term investments in size. This increasing flow of money participation further reinforces and ensures the directional movement.

If this sounds like the basis of a great investment strategy, it certainly can be. And, while it’s reasonable to assume that varying forms of RS trading will continue to succeed in the future, the approach does have several potential pitfalls. In the next part of this series, we’ll explore these shortcomings, and examine how TAM addresses many of these as a superior portfolio risk management approach.

Tactical Asset Management

Last month we suggested an investment edge could be achieved by periodically rotating capital into those market sectors with the strongest “relative strength”. We also noted that this strategy may have had some hidden flaws and this month we review two of those flaws and outline a remedy the average investor can engage to control risk exposure and avoid loss of capital.

Flaw #1: Extreme care must be taken when building a relative strength portfolio to assure that the assets are not highly correlated. Recent market behavior has dramatically demonstrated this point as virtually all market sectors have declined except bonds. It does no good to have a rotation model of assets if we can only rotate from poorly performing assets into less poorly performing assets.

Flaw #2: Different asset classes have wildly different risk characteristics which are commonly referred to as “beta” in market speak. The higher the beta the higher the volatility and hence, the higher the risk. When the market moves, higher beta assets will rise or drop disproportionately. This is a good thing if you happen to be on the right side of the market but can be frightening if the market moves against your position.

A simple yet effective remedy to these otherwise unpredictable market risks is often referred to as Tactical Asset Management (TAM), a financial engineering process that puts a new twist on classic risk management. Most investors have been told that diversification is the best way of spreading out your bets in the market so that chances of all of them being wrong at once is low. Unfortunately, this theory occasional falls apart, as it did in late 2008 when the market plunged 50%. Losing 50% in the market in 2008 means that you need to make 100% just to recover your capital. However, if you can create a strategy that captures most of the gains of stocks in bull markets but avoids most of the losses in bear markets then you can save years of having to recover your capital. This is the goal of tactical asset management.

TAM accomplishes its goal by allocating assets to a portfolio that do not have a strong correlation—that is, they do not go up and down together—this is the new approach to diversification. In general, the lower the correlation, the better the diversification benefit. Thus, it’s important to include as many assets that have a low correlation as possible in your portfolio and in this way minimize the chance of being wrong on all of them at once.

Recent market studies have shown that proper allocation decisions in portfolios account for nearly 95% of the range of investor performance. In contrast, finding the best stocks is only 5% of the game. Getting the asset allocation decision right is the only way to consistently do well in both bull and bear markets. In today’s environment, the correlation between stocks is so high that when the market falls substantially the chances are virtually certain that even the best stocks will follow suit. However, the best asset classes—whether stocks, real estate, bonds, gold or even cash—will almost certainly outperform the market by a substantial margin.

TAM strategies are widely used by hedge funds and mutual funds to add value to their portfolios – and you can too. If we merge our relative strength tactic with a TAM non-correlated portfolio we now have a guide to construct a portfolio that delivers the best of both worlds, maximum risk control and sensitivity to market trends.

Disclaimer

Indio, California . . After 27 years of trading, I'm still exploring market opportunities. These posts are the product of my on-going research and are not solicitations to purchase or trade specific securities.
I am not a registered trading advisor or licensed investment professional. I am also not liable for damages arising from any investment actions made after reading ETF Mosaic Solutions.
We endeavor to provide reliable quantitative investment models but it must be emphasized that past performance is absolutely no guarantee of future returns.Trading is inherently filled with risk and you alone are responsible for your financial decisions.
Contact me at bzbtrader@aol.com

Wednesday, September 24, 2014