Nate Geraci
September 20, 2010
Asset allocation is a fancy name to describe how a portfolio is divided among asset classes; i.e., what percentage of an overall portfolio is in bonds, stocks, real estate, etc. Contrary to what the financial services industry would have you believe, asset allocation is not filling in your Morningstar style boxes like some game of bingo. Another overly simplistic rule of thumb is you should take 100 minus your age and that is the percentage that should be in stocks and the rest in bonds. Anyone following these “methods” over the last decade is probably not real happy with the results.
There is a different way. A way that manages risk, is tax efficient and finds those areas with solid returns. That way is applying a trend following or relative strength philosophy to asset allocation. Trend following has been around for hundreds of years and has been analyzed, pushed, prodded and poked by a multitude of academics, analysts and researchers. They have uniformly found that trend following beats the market over time. Shhhh – don’t tell the efficient market believers.
In fact, popular indices like the S&P 500 index are extremely difficult for amateur and professional investors to beat. The popular wisdom is that this is because the market is efficient. The dirty little secret is that these indices, because of how they are constructed, actually follow a trend following or relative strength strategy.
The S&P 500 index is generally comprised of the 500 largest capitalization stocks headquartered in the US. Stocks in the S&P 500 that outperform the index become a bigger portion of that index since the index is market cap weighted. Stocks in the S&P 500 that underperform the index become a smaller portion. This is a relative strength strategy – let the winners run and cut the losers. The S&P 500 index periodically adds new firms that grow and qualify for inclusion – i.e., buys winners; and periodically kicks out companies that no longer qualify – i.e., sells losers. This strategy is a relative strength or momentum strategy – buy or add to positions that are outperforming and sell or subtract from positions that are underperforming. This relative strength strategy actually is a very big reason this index is so hard to beat.
Relative strength investing can be applied to your entire portfolio. This is commonly called tactical asset allocation but to me it is just common sense. A simple way to apply relative strength to your portfolio is to first decide which asset classes to which you want exposure. In the past, unless you had several million dollars to give to a hedge fund or specialized investment manager, this meant stocks and bonds. One of the huge advantages that ETFs bring to the table is exposure to many more asset classes: gold, commodities, emerging market stocks, different types of bonds, interest rates and currencies. This advantage allows individuals to employ strategies that a decade ago were extremely costly to implement. The second step is to rank those asset classes by recent performance. You would then buy or add to those asset classes that ranked high – i.e., have performed well; and sell or subtract from those asset classes that ranked poorly.
An simple example may help explain this strategy: my friend “Bob” chooses the following asset classes to consider: large cap US stocks, small cap US stocks, international stocks, emerging market stocks, US treasuries, corporate bonds, international bonds, China, gold and commodities. There are liquid, inexpensive ETFs for each of these 10 categories. Every three months, he ranks these 10 ETFs by their past 12 month total returns. He then rebalances his overall portfolio so that 75% of his portfolio is in the top five ETFs and 25% is in the bottom five ETFs.
Relative strength investing will not get you out at the tops or in at the bottoms in the financial markets. There are no strategies, processes, gurus, tools or tea leaves that will consistently call tops or bottoms in markets. As asset classes or financial markets start to deteriorate, a relative strength strategy will rotate your portfolio away from those areas and into those showing strength or improvement. Bear markets in all asset classes are not sudden affairs – they take time to play out. The most recent bear market in global equities took 18 months to play out. Even the crash of 1987 was not a sudden affair – the US stock market started showing signs of deterioration well before that October. This rotation away from deteriorating asset classes is a key risk management tool as the bulk of declines tend to come in the later stages of bear markets.
Another way to think of relative strength investing is with the old adage that there is always a bull market somewhere. A relative strength strategy seeks to find those bull markets. Simply shifting some assets into areas of strength and away from areas of weakness can make a huge difference in returns.
Popular wisdom holds that buy and hold is the way to go – or at least it was until 2000. Popular wisdom also holds that you should hold both stocks and bonds. The press is breathless with stories about which professional investor has the “hot hand.” Interestingly, the vast majority of variability in an investor’s portfolio returns is not due to which stock or mutual fund or ETF was chosen for each asset class. The vast majority of variability of returns comes from how much is invested in each asset class. Whether investors considered 2008 a good or bad year for their portfolios depended on how much they had in stocks versus how much they had in bonds. Investors who owned what was strong in 2008 – bonds – and avoided what was weak – stocks and commodities – likely were much happier than those buy and holders who stuck with stocks.
