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Upping the Ante: The Effects of Applying the Concepts of Relative Strength Selection to a Still More Volatile Portfolio of Mutual Funds

Let's try the procedure just one more time, this time with a universe of mutual funds that includes the most volatile sectors in the equity spectrum. This universe includes all the high-rolling areas of the stock market—gold, the internets, small caps, technology, whatever—as well as lower-volatility funds, encompassing the complete spectrum of mutual funds rated by volatility as 1–9.

Figure 1.7

Chart 1.7 Performance of the Relative Strength Investment Approach (1990–2003), Including All Mutual Fund Groups, Rated as 1–9

Rates of return for the best deciles in the 1–9 universe remained in the area of returns secured from lower-volatility mutual fund universes 1–5 and 1–7. However, risks increased considerably, as you can see by the drawdowns reflected on the chart. The first-performance decile for the previous quarter proved, again, to be the best for the subsequent quarter, although the lead over the second-best-performing decile the previous quarter was not great.

Let's review, just one more time, a tabular table.

Investment Results of Quarterly Rebalancing (June 1990–October 2003)Mutual Funds with Volatility Ranks 1–9 (Virtually All Equity-Oriented Mutual Funds, Including Those Considerably More Volatile Than the Standard & Poor's 500 Index)

Performance Decile

$100 Becomes

Gain Per Annum

Maximum Drawdown

First decile

$596.31

+14.1%

20.3%

First decile

$614.44

+14.3

40.2

Second decile

605.24

+14.3

34.2

Third decile

539.98

+13.3

31.5

Fourth decile

454.66

+11.9

38.6

Fifth decile

388.29

+10.6

39.9

Sixth decile

335.07

+9.4

41.8

Seventh decile

330.19

+9.3

42.2

Eighth decile

296.95

+8.4

43.7

Ninth decile

267.68

+7.6

43.1

Tenth decile

173.97

+4.2

50.1

General Observations

Again, we see a very linear relationship between fund performance in a previous quarter and its performance in subsequent periods. Within the highest-velocity mutual fund group, the second decile runs very closely in strength to the first decile. I have found this to be the case in studies I have conducted of other ways to employ past relative strength to predict future market performance. It seems that, among the most volatile mutual fund areas, more consistent performance is sometimes attained from second and third decile holdings than by first, although, in this study, the first decile produced the best rates of return.

The average gain/maximum drawdown ratio for even the strongest (first decile) area of the 1–9 group of mutual funds is low, at 0.36 (14.39 rate of return, 40.18% maximum drawdown). The gains can be there, but the pains can be considerable, indeed, for investors who live in the fast lane.

Although portfolios are rebalanced at quarterly intervals, this does not mean that you will have to replace your entire portfolio each quarter. On average, holdings are likely to be maintained through two quarterly cycles, or for six months in total.

Conclusion: Increasing the volatility of your mutual fund portfolio does not add to profitability in any significant manner, even though risk levels do increase. As a general rule, your emphasis should remain with funds of average or below-average volatility.

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