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This chapter is from the book

Changing Your Bets While the Race Is Still Underway

Let's suppose you have a choice.

You go to the racetrack to bet on the fourth race, research the history of the horses, evaluate the racing conditions, check out the jockeys, evaluate the odds, and finally buy your tickets. Your selection starts well enough but, by the first turn, starts to fade, falling back into the pack, never to re-emerge; your betting capital disappears with the horse. The rules of the track, of course, do allow you to bet on more than one horse. The more horses you bet on, the greater your chances are that one will come through or at least place or show, but then there are all those losers....

Then you find a track that offers another way to play. You may start by betting on any horse you choose, but at the first turn, you are allowed to transfer the initial bet—even transfer your bet to the horse leading at the time. If the horse is still leading at the second turn, you will probably want to hold your bet. If the horse falters, however, you are allowed to shift your bet again, even to the horse that has just taken the lead. Same at the third turn. Same at the final turn. You can stay with the leaders, if you like, or, if your horse falls back into the pack, you can move the bet to the new leading horse until the race comes to an end. (I have, of course, taken some liberties with the analogies, to make a point.)

Which way do you think you'd prefer? Betting and holding through thick and thin, and, perhaps, through your horse running out of steam? Or shifting bets at each turn so your money starts each turn riding on a leading horse?

The first track is a little like the stock market, whose managers seem always to be telling investors what to buy, sometimes when to buy, but rarely, if ever, when to change horses. Buy-and-hold strategies do have their benefits, particularly over the very long term. It is possible, after all, for all stock market investors to make money in the end, which is not true for all bettors at the track.

The second track, however, is more likely to give an edge to the player. Strong horses tend to remain strong, especially when you don't have to ride them to the finish line if they begin to lose serious ground. That brings us to relative strength investing.

Relative Strength Investing

The basic principles of relative strength investing are as follows:

  • Identify the leaders.
  • Buy the leaders.
  • Hold the leaders for as long as they lead.
  • When the leaders slow down, sell them and buy new leaders.

Simple enough?

Let's get more specific.

For investors of average to below average risk tolerance, start by securing a database or two of a large number of mutual funds. I prefer a database of at least 1,000 mutual funds—preferably more, but for the purposes of a single investor instead of a capital manager, a few hundred is almost certainly sufficient.

You need quarterly data, so almost any source that tracks mutual funds and provides quarterly performance data serves your purpose. Barron's the Dow Jones Business and Financial Weekly, for example, provides good coverage. Other sources can be found on the Web.

For example, in the Finance areas of Yahoo.com and MSN.com, you can find charts and information regarding mutual funds. A number of investment advisory newsletters provide performance and other information regarding mutual funds. Newsletters that provide recommendations and data specific to the sort of investment approach I am suggesting include my own newsletter, Systems and Forecasts, and the newsletter No-Load Fund X. You can find information regarding these publications at http://www.Signalert.com and http://www.NoloadfundX.com, respectively.

Conservative investors should eliminate from the array of funds covered those that are normally more volatile than the Standard & Poor's 500 Index. Such funds often provide excellent returns during strong and speculative market climates, but you will probably secure better balances between risk and reward if you concentrate your selections on mutual funds that are, at most, just somewhat above (preferably approximately equal to or below) the Standard & Poor's 500 Index in volatility. Your portfolio, when fully invested, will probably include holdings that are, on average, approximately 80–85% as volatile (risky) as the Standard & Poor's 500 Index. Actual risk is likely to be reduced below these ratios as a result of the exceptional relative strength of your holdings. (More on this comes shortly.)

When you have isolated a universe of mutual funds whose volatility is more or less equal to or less than the Standard & Poor's 500 Index—for example, the Dodge and Cox Balanced Fund and First Eagle Sogen—determine from the performance tables which funds have shown performance results over the past three months that rank in the upper 10% (top decile) of all the mutual funds of similar volatility in your database. These are funds that have shown the greatest percentage gain for the period.

Buy a selection of at least two—preferably four or five—funds in the top decile of the mutual fund universe that consists of funds of equal or less volatility than the Standard & Poor's 500 Index. Some level of diversification is significant. Even a portfolio of as little as two mutual funds provides considerable increase in safety compared to a single-fund portfolio. Look for funds that charge no loads for purchase and involve no redemption fees for holding periods of at least 90 days.

Review your portfolios every three months, as new quarterly data becomes available. If any funds have fallen from the top decile, sell those funds and replace them with funds that remain or have just entered into the top decile in performance. Maintain current holdings that retain their positions in the top 10% of performance of all mutual funds of that volatility group.

Funds should be ranked against their own volatility peers. During rising market periods, funds of higher volatility tend to outperform funds of lower volatility simply because higher-volatility mutual funds and stocks tend to move more quickly than funds and stocks of lower volatility. Conversely, higher-volatility positions tend, on average, to decline more quickly in price than lower-volatility vehicles. We are seeking funds that produce the best returns for varied market climates, including both advancing and declining market periods. You can secure volatility ratings of mutual funds from a variety of sources, including Steele Mutual Fund Expert (see http://www.mutualfundexpert.com), an excellent reference for mutual fund information.

If you follow this procedure, you will regularly rebalance and reapportion your mutual fund holdings so that, at the start of every quarter, you will hold a portfolio of mutual funds that have been leading their peer universe in strength. Your portfolio will consist of mutual funds with the highest relative performance, horses that are leading the pack at every turn of the course.

Testing the Relative Strength Investment Strategy: A 14-Year Performance Record of Relative Strength Investing

Figure 1.5

Chart 1.5 Performance of the Relative Strength Investment Approach (1990–2003)
Chart 1.5 shows the performance of ten performance deciles of mutual funds from 1990 to 2003. The assumption is made that, at the start of each quarter, assets are rebalanced so that investments are made only in funds that are ranked in the top 10% of performance for the previous quarter among mutual funds whose volatilities were equal to or less than the volatility of the Standard & Poor's 500 Index. The initial universe in 1990 was approximately 500 funds, increasing over the years to more than 3,000 by 2003. Performance was very consistent with rankings. This chart is based upon hypothetical research.

Chart 1.5 shows the results of a hypothetical back-test of this procedure of maintaining a portfolio of mutual funds of average to below-average volatility, reranking in performance each quarter, reallocating your holdings at that time by selling positions that have fallen from the top 10% in performance, and selecting and replacing such positions from those funds that have remained or recently entered into the upper decile.

Again, it goes without saying that this program should be carried out with no-load mutual funds that charge redemption fees only if assets are held less than 90 days. Brokerage firms such as Schwab and T. D. Waterhouse, as well as many others, provide platforms of no-load mutual funds from which you can make selections. Our research universe included equity, balanced, and sector mutual funds. Your own universe can be similarly created.

Rebalancing can take place more frequently than at 90-day intervals, if you prefer. For example, somewhat higher rates of return appear to accrue when ranking and rebalancing procedures take place at monthly rather than quarterly intervals. However, more frequent portfolio rotations result in increased trading expenses and probable increases in mutual fund redemption fees, all of which could well offset the advantages gained by more frequent portfolio reallocation. A program of rebalancing at intervals of more than three months is also likely to provide considerable benefit, although returns are likely to diminish somewhat as a result.

There is another significant reason to reduce trading frequency. As a result of scandals during 2003 and 2004 that took place related to mutual fund timing, mutual fund management companies and the distribution network of mutual funds became more sensitive to frequent trading by active market timers as a source of possible fund disruption. Close monitoring of active investors has become the norm, with frequent traders banned from investing in certain funds. In this regard, it is probably more prudent from your own public relations standpoint not to wear out your welcome with excessive trading.

ETFs may be traded with no restrictions, apart from trading expenses, which do mount with frequent trading and is something to definitely consider. Our own research, however, suggests that although the program of relative strength rebalancing just described is likely to improve on random selection of ETFs, the strategy appears to perform better when it is applied to mutual funds. ETFs seem more likely to show rapid gains or losses in inconsistent patterns than mutual funds and, as a group, tend to be more concentrated and volatile than lower-volatility mutual funds. That said, research carried forth by Signalert Corporation and research discussed in the newsletter Formula Research confirms the validity of applying relative strength rebalancing strategies to at least certain ETFs. For the most part, using mutual funds is recommended.

Incidentally, significant benefits might be achieved by rebalancing your portfolios at intervals of as long as one year. At the start of each year, you purchase mutual funds that were in the top decile of performance the year previous, hold them for a full year, and then rebalance at the start of the next year. Annual rebalancing does not appear to produce quite as high rates of pretax return as rebalancing quarterly, but given reductions in possible transaction costs and more favorable tax treatment, net gains could well prove to be the equal of quarterly rebalancing.

Results of Quarterly Reranking and Quarterly Rebalancing (1990–2003)

As you can see in Chart 1.5, an almost perfect linear relationship develops if you maintain your portfolio in funds of the different deciles and rebalance at the start of each quarter. The top decile is highest in performance; the lowest decile at the start of each quarter produces the lowest rates of return.

Here are the results in tabular form.

Investment Results of Quarterly Rebalancing (June 1990–October 2003) for Mutual Funds with Volatility Ranks 1–5 (Below or Equal to the S&P 500 Index)

Performance Decile

$100 Becomes

Gain Per Annum

Maximum Drawdown*

First decile

$596.31

+14.1%

20.3%

Second decile

556.85

+13.6

24.0

Third decile

508.53

+12.8

27.4

Fourth decile

427.32

+11.4

27.4

Fifth decile

368.06

+10.1

31.6

Sixth decile

327.59

+9.2

34.8

Seventh decile

337.09

+9.4

35.6

Eighth decile

303.17

+8.6

37.0

Ninth decile

275.22

+7.8

35.0

Tenth decile

184.31

+4.6

40.1

* Maximum drawdown is the largest decline in the value of your portfolio from its highest peak level before the attainment of a new peak value. Although it cannot be said that past maximum drawdown represents maximum risk, it can be said that past maximum draw-down certainly does represent minimum portfolio risk.

Buy-and-Hold Results: The Standard & Poor's 500 Benchmark

By comparison, the Standard & Poor's 500 Index, on a buy-and-hold basis, produced a total return (including dividends but not investment expenses) of 10.8% per annum during this period, with a maximum drawdown (the greatest reduction of capital before your portfolio reaches a new high in value) of 44.7%. The Vanguard Standard & Poor's 500 Index fund achieved an annual rate of return of 10.7%, with a maximum drawdown of 44.8%. These returns fell between the fourth and fifth deciles of the funds in our study on a buy-and-hold basis, just about what would be expected, given the lower comparative volatility of the mutual fund universe employed.

A program of investment in the highest-ranked decile of low- to average-volatility mutual funds, reallocated quarterly, produced an annual return of 14.1%, compared to 10.8% for buying and holding the S&P 500 Index. Moreover, and possibly more significant, the maximum drawdown of this first-decile portfolio was just 20.2%, compared to 44.7% for the Standard & Poor's 500 Index. More return. Less risk. More gain. Less pain.

If your account is housed at a brokerage house, you will almost certainly be able to trade in ETFs as well as mutual funds. You might establish an ETF universe for relative strength rotation, or you might include ETFs in the universe you rank each quarter, treating each ETF as though it were a mutual fund. Again, ETFs tend to be somewhat less stable in their movement than many mutual funds but, as more are developed, might prove to be worthwhile adjuncts to mutual funds.

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