One of our premier sources for technical information is NASDAQ Dorsey Wright. Last December, they published their annual series called The 12 Days of Christmas. In those 12 columns last December they highlighted major concepts from the video on our website (Link: We Are Not Your Old Stock Broker), and expanded on each in depth. I have been blogging about one of those 12 topics monthly all year and will wrap up in November. My purpose is not to make you experts on tactical strategies, but merely to give you a sense of the process and diligence that we perform daily to help minimize the damage to you should a large decline hit the market as well as properly construct portfolios that meet your goals.
Today, we discuss the importance of dispersions within tactical strategies and how rotation over time can add value within portfolios. As important as having a sound investment process is, equally important is having the ability to articulate that process. When describing a relative strength-based process, which inevitably involves rotation over time, it’s important to incorporate a consideration of dispersion of returns. Market dispersion is sometimes an interesting bedfellow, or "fair weather friend" if you'd prefer, but is nonetheless a key component of relative strength. Setting an appropriate expectation is important, which means highlighting some of the pros and cons of the methodology and noting that the success of rotational strategies depends largely upon the magnitude of performance dispersion within our investment inventory.
When we refer to dispersion, we are also describing the opportunity available to tactical strategies, which is best quantified by the performance difference between the best and worst performing sectors or asset classes. Relative strength-based strategies tend to offer excess return over their benchmark more readily when the dispersion between the best and worst performers is very wide. The reason for this is fairly straightforward - the more divergence that exists between the best and worst performers, the more potential value we can add by being in good performing assets and avoiding the bad performers; when there is more dispersion there is more potential for a tactical decision to produce a meaningful result. On the other hand, such strategies will tend to suffer, or at least become muted when dispersion is narrow. Taken to an extreme, if all investment possibilities were up the same amount each month and each year, there would be limited opportunity for a tactical manager to add value via rotation. Even if small dispersions existed, the pressure for every decision to be right would be high, as we all must justify our existence in this business at some point.
In the graph below, we have displayed the dispersions between, as well as within, several asset classes going back to 1998. Through the end of the third quarter 2017, the average dispersion between the asset classes is 31.18% and the dispersion during 2017 is actually below that average, standing at 25.94% (thru 12/22). But that doesn’t mean there was not opportunity to generate excess returns via rotation. When we isolate each asset class and look at the dispersion within each one, we find that there are significant performance dispersions within US Equities, International Equities, and Commodities. For example, the difference between the best and worst performing industry group within US Equities averages nearly 100% each year. With this information we can deduce that applying relative strength to US sectors or industry groups is another viable way to increase the portfolio’s value over time.
Until next time, cheers!