An Allocation, Not A Trade

by: Dorsey Wright Money Management

By Andy Hyer

Corey Hoffstein makes a compelling argument for why active strategies should be treated as an allocation, not a trade:

Many studies have shown that there are numerous characteristics that can deliver superior risk-adjusted returns over time. The most popular include value, size, momentum, trend-following, quality, low-volatility and high yield.

Most active managers tend to align their portfolios one, or several, of these factors.

None of these characteristics, however, out-performs in all markets. In the short-run, their relative out-performance to the market can vary considerably.

A value tilt, for example, has historically delivered an average 2-year return premium of 547 basis points ("bp") over the broad US equity market. In the short run, it has seen periods ranging between -4046bp and +5753bp.

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Source: Kenneth French data library. Analysis by Newfound Research.

As we've said before, investors do not experience "average." They experience under-performing the market by -40% over two years before they experience out-performing the market by 57%, assuming they did not sell and go to a different manager.

Further on in his article, he looks at some popular factor tilt premiums over the last 20 years (1995-2015) and shows that they went through significant and prolonged drawdowns relative to the S&P 500.

Can we blame investors who gave up on a value tilt after under-performing the market by 31.90%? That relative drawdown, from peak-to-recovery, took 8 years.

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None of the factor tilts went unscathed and yet they all were able to generate excess returns over this 20-year period of time. As proponents of momentum investing, it is worth noting that momentum had the highest annualized premium of any of those shown in the article.

Investing is hard. I fully understand the argument put forth by John Bogle and others that investors should just buy a cap-weighted index and forget about trying to outperform the market. For many investors, that is probably the right answer. However, research suggests that excess returns are available and Hoffstein's study provides some important clues about asset allocation best practices.

First, do your homework to know what factor tilts have historically generated outpeformance. Second, do sufficient due diligence to come to a conclusion about whether or not those factor premiums are likely to continue. Third, allocate across a number of factor tilts, preferably among several that have a relatively low correlation to one another. Fourth, don't trade in and out of those active factor tilts unless you have a crystal ball.