John Lewis, Nasdaq Dorsey Wright's senior portfolio manager, breaks down numerous topics that are top of mind for many investors, highlighting the opportunities for a relative strength approach to investing.
Q: Do you believe that it is possible to identify good times to add money to relative strength strategies or do you think investors are better off just dollar cost averaging?
JL: Yes, there are better times than others to add money to relative strength strategies. Relative strength (momentum) strategies tend to have sharper periods of underperformance and recovery versus more traditional factors like growth or value. These periods of relative drawdown can be used to the investor’s advantage. These periods of sharp underperformance are the ideal time to add funds to RS strategies. Investors tend to do the opposite. When RS is out of synch with the market they often assume momentum is “broken” or the model needs to be totally revamped. However, underperformance in an RS strategy leads to changes. By definition, if you are underperforming the market you don’t own the leadership. Any RS strategy is designed to find leaders and avoid laggards so underperformance causes the portfolio to begin to adapt. We can never be sure how long that process of finding the new leadership will take, but eventually these strategies find the new leadership. That adaptation is why it is advantageous to add to RS strategies when they underperform. That is much easier said than done though. Over the years we have generally observed very few investors adding during drawdowns. Most investors prefer to sell when RS strategies are out of favor.
Q: Tell us about any principles that you try to follow when managing your own personal money.
JL: I try to keep things as simple as possible. I want to invest in things that have an exploitable edge over a long period of time, and then I let that work for me. In order to find those types of strategies you have to be willing to do something that is uncomfortable at times or that other investors are unwilling to do. If it was easy, there would be no alpha in the strategy! Everything I own are strategies I understand really well. When they don’t perform as expected I understand them well enough to assess why and determine if they are simply out of favor or if something has happened that would cause me to reassess the strategy. With very few exceptions, the strategies I own are the same things the clients own. I have a great deal of confidence that despite the inevitable bumps in the road, RS strategies are where I want to be long-term. Of course, individual investors should consult with their financial advisor when making financial investments.
Q: When did you first start calculating the relative strength spread? What can an investor learn by observing the RS Spread over time?
JL: We started calculating the spread over 10 years ago so we have a lot of experience with it. The RS spread simply measures the performance of high momentum stocks versus low momentum stocks. That performance difference is plotted over time, and gives a good indication of the health of the momentum factor over time. When you look at a very long-term chart, the spread is upward sloping. This means over time the leaders outperform the laggards. But when you look at shorter time periods the spread can be very choppy. The path to outperformance goes through cycles, and the leaders aren’t always outperforming laggards. If we are underperforming and the spread is falling, that would be normal. When the spread rises we expect to outperform. When our performance isn’t moving the same way as the spread we look in to why that is happening. The RS Spread really gives us a nice picture of how the whole momentum market is performing over time.
Q: There seems to be a never-ending debate among quants about whether models should be viewed as a work in progress where the rules can/should be tweaked over time or whether they should be left alone and just executed systematically. What is your view on this question?
JL: I think there are two things to address here. The first is whether you should constantly change your ruleset. We have stayed away from that over the years mainly because when you change the rules you wind up like a dog chasing its tail. You are always fighting the last battle. Some strategies do require changes if the focus on things than can undergo a massive regime change. A model that uses a lot of economic data might fall in to that category. Momentum, on the other hand, simply pushes toward strength. That is pretty simple, and we know it exists at intermediate-term time horizons. Your strategy is never going to have the exact, optimal momentum measurement, but the factor is robust enough that it works without having to tweak it constantly over time.
The second issue is whether to deviate from your rule set under extreme conditions. We see this quite a bit, but we have stayed away from it. The reason we run things systematically is so we can evaluate investments the same way regardless of market conditions or outside noise. Managing money is a little like flying an airplane. It’s pretty uneventful most of the time. During those times you can deviate from your plan and not get hurt too much. But there are short periods of extreme stress when deviating from your plan can be catastrophic. Pilots have a checklist they run through during emergencies. The checklist ensures they are sticking to the ruleset because decision making becomes more difficult under that type of stress. Similarly, in times of market stress decision making becomes clouded. Investors do the wrong thing all the time. That is why we feel sticking to the process is most important under times of market stress, which is when most people tend to deviate from their plans.
Since 2005, Nasdaq Dorsey Wright’s portfolio management team has managed Dorsey Wright Systematic Relative Strength strategies that are available today as separately and unified managed accounts (SMAs/UMAs). All of our managed accounts use a disciplined approach that seeks to capitalize on long-term trends. Our investment universe and model constraints differ from strategy to strategy, resulting in different risk and return profiles. For more information, contact us here or download a copy of our latest performance brochure here.
Dorsey, Wright & Associates, LLC, a Nasdaq Company, is a registered investment advisory firm. Registration does not imply any level of skill or training. Neither the information within this email nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products. This communication does not purport to be complete description of the securities or commodities, markets or developments to which reference is made.
The relative strength strategy is NOT a guarantee. There may be times where all investments and strategies are unfavorable and depreciate in value. Relative Strength is a measure of price momentum based on historical price activity. Relative Strength is not predictive and there is no assurance that forecasts based on relative strength can be relied upon to be successful or outperform any index, asset or strategy.
In all securities trading there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal previous performance. Investors should have long-term financial objectives. There are risks inherent in international investments, which may make such investments unsuitable for certain clients. These include, for example, economic, political, currency exchange, rate fluctuations, and limited availability of information on international securities. Past performance, hypothetical or actual, does not guarantee future results. In all securities trading there is a potential for loss as well as profit. It should not be assumed that recommendations made in the future will be profitable or will equal the performance as shown. Investors should have long-term financial objectives. Advice from a financial professional is strongly advised.