Friday, October 5, 2012

Combining Factor Investing & Relative Strength

I get Morningstar Advisor magazine free every month.  I usually find little value in it as most articles are buy and hold drivel but this month they had some interesting articles devoted to factor investing.  Numerous studies have been done that identify certain factors that have outperformed the market:

1. Value investing
2. Momentum
3. Smaller stocks
4. Low Beta Stocks

Momentum is obviously something that has always interested us.  As has value, since it is not correlated with momentum.  We are constantly studying ways to apply value across asset classes and see how it can be combined with momentum strategies (perhaps the subject of another post one day).  The others have never really had any interest to us as they may outperform the market but they also will get creamed when the market goes down.  Momentum is the only one of these factors that can be tweaked to avoid large losses.  However, the articles got me thinking about combining relative strength (buying the one asset out of a basket of assets that has the strongest performance over a period of time) with factors.  So I decided to study whether this would work.  I tried to find ETFs or mutual funds to represent each of the factors that have been around a long time (I had some trouble with this and more work needs to be done to find stuff that has been around longer).  I settled on the following:

Momentum- Powershares Tactical Leaders
Low Beta- SEI Managed Volatility
Value- iShares Large Cap Value
Small Cap- iShares Russell 2000
Tactical- PIMCO All Asset (Threw this in there as well to provide a little diversification)

I designed a simple relative strength system that would rotate monthly among the best performing fund and would be in cash if nothing was in an uptrend.  I was able to go back to 3/2007 for a common history but since we needed time to determine relative strength my first trade wasn't until 2/25/09.  Here are the results from 2/25/09 to 10/4/12:

Average Annual Return: 21.11%
Maximum Drawdown: -15.37%
Worst Month: -7.16%
Sharpe Ratio: 1.32
MAR Ratio: 1.37

The performance numbers and MAR are very attractive but the drawdowns and worst month are a little high for my taste.  I also really would have liked to see what this would have done in 2008.  That being said, there is definitely enough here for further study and refinement.

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