Using Momentum And Hedge Funds To Build A Better Portfolio

by: Brian Haskin

Welles Wilder revolutionized the investment world in 1978 when he developed the Relative Strength Indicator ("RSI"). RSI was one of several new technical indicators that helped individual investors move away from static "60/40" or "70/30" stock/bond asset allocations as trading commissions plummeted in the wake of discount brokerages displacing more expensive "full-service" offerings.

Now, nearly forty years later, Berkeley Square Capital Management has a new take on RSI - and the traditional "70/30" allocation. The firm combines the two concepts, while adjusting RSI from a short-term indicator based on the past 14 days to a longer-term momentum indicator based on the past 12 months, and also adding hedge funds to the allocation mix - "50/30/20." What's more, Berkeley Square's momentum strategy differentiates between the best and worst sectors within each asset class, taking advantage of reduced commission charges by rebalancing its portfolios as frequently as warranted to maximize risk-adjusted returns.

Sector Breakdowns

Rather than allocating 50% to the S&P 500, 30% to the Barclays Aggregate, and 20% to the HFRI Hedge Fund-Weighted Composite ("FWC"), Berkeley Square breaks each of the broad indices down into its composite sectors, and then assigns RSI rankings to each. The top five sectors from each asset class are then weighted to comprise the total "50/30/20" portfolio.

Among equities, Berkeley Square looks at the S&P 500's ten composite sectors:

  • Energy
  • Materials
  • Industrials
  • Consumer discretionary
  • Consumer staples
  • Health care
  • Financials
  • Information technology
  • Telecommunications
  • Utilities

For fixed income, Berkeley Square looks at the following Barclays Total Return indices:

  • S. Corporate Investment Grade
  • Intermediate Corporate
  • Long U.S. Corporate
  • S. MBS
  • GNMA
  • S. Long Credit
  • S. Aggregate Government/ Credit

And for hedge funds, the following HFRI strategy style indices are considered:

  • ED: Merger Arbitrage
  • EH: Equity Market Neutral
  • EH: Short Bias
  • Emerging Markets (Total)
  • Equity Hedge (Total)
  • Event-Driven (Total)
  • Fund of Funds Composite
  • Macro (Total)

Frequency of Rebalancing

The frequency of portfolio rebalancing should always be scaled to maximize risk-adjusted returns. According to Berkeley Square's findings, equity holdings are best rebalanced monthly, which has historically yielded a return per unit of risk of 0.76 - compared to risk-adjusted returns of 0.56 for annual rebalancing, 0.59 for semi-annual, and 0.66 for quarterly. By contrast, bond holdings perform best when rebalanced annually, and hedge-fund holdings when rebalanced quarterly.

Independent Returns

Adding hedge funds to the asset allocation has slightly improved returns, historically, but more greatly improved risk-adjusted returns. As Modern Portfolio Theorist Harry Markowitz said, "Expected return is a desirable thing and variance of a return is an undesirable thing" - so rational investors should prefer more stable returns to more volatile returns, all other things being equal.

From 1991 through 2014, the S&P 500 Total Return Index generated compound annualized returns of 10.18%, compared to the HFRI FWC's 10.81%. But the S&P's annualized standard deviation of 18.39% yielded a return per risk unit of 0.55, while the HFRI FWC's much lower 12.11% annualized standard deviation yielded a 0.89 return per unit of risk. The Barclays Aggregate Index of bonds, by contrast, yielded much lower annualized returns of 6.39%, but with even lower annualized volatility of 4.97%, its return per unit of risk was the highest at 1.29.

berkeley square dynamic portfolio

Putting it all Together

What's important, of course, is how the three asset classes act together, within a single portfolio: According to Berkeley Square's research, the "50/30/20" portfolio - even without rebalancing - outperformed "70/30" with annualized returns of 9.58% from 1991 through 2014, compared to the "70/30" portfolio's returns of 9.48% over that same time. More importantly, "50/30/20" outperformed on a risk-adjusted basis, with a return per unit of risk of 0.85 compared to the "70/30" portfolio's 0.72.

But what about when Berkeley Square's dynamic reallocation system was followed? In this case, the "50/30/20" portfolio's annualized returns were boosted to 10.92% with return per unit of risk of 1.16, besting even the long-only S&P 500 Total Return Index's 10.18% returns, and with much less volatility.

For more information, download a pdf copy of the white paper.

Jason Seagraves contributed to this article.

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