Investment advisors continuously seek strategies that promise a better risk-adjusted return for their clientele. One such strategy that has been gaining traction is the Relative Strength Approach to portfolio selection. This methodology, rooted in momentum investing, entails selecting portfolios based on their performance relative to other portfolios. Here we'll delve into the benefits of a relative strength approach, along with discussing a few drawbacks such as high turnover and risk objective drift.
POTENTIAL Benefits:
Riding the Wave
Portfolios with superior relative strength frequently outperform others due to the momentum they carry, which can last for an extended period of time. Investors can potentially increase returns by identifying and investing in these portfolios. By comparing their performance to benchmarks or other portfolios, the relative strength approach aids in identifying such portfolios. This strategy essentially rides the wave of existing market trends, capitalizing on the continued success of stronger performing allocations, thus providing an opportunity for potentially improved returns.
Ease of Implementation
The relative strength approach is built on simplicity and objective assessment. It operates on a clear principle: compare the performance metrics of various portfolios and reallocate assets towards those exhibiting superior momentum. Unlike subjective methods, this strategy doesn't require extensive analysis of individual assets or market predictions, it merely follows the data. By tracking the performance metrics over a defined period, advisors can identify which portfolios are outshining others. This straightforward methodology provides a clear framework for decision-making, making the asset allocation process more streamlined and less ambiguous for investment advisors.
Automatic Response to Market Conditions
The Relative Strength / Price Momentum strategy is fundamentally designed to align with prevailing market trends by gauging the momentum of different allocations. When a particular allocation is performing well, it demonstrates higher relative strength compared to others. Consequently, an investment approach based on relative strength will naturally gravitate towards holding a larger proportion of assets in these well-performing areas, thus being overweight in them.
Risk Management
By concentrating on portfolios exhibiting stronger performance, advisors have the opportunity to avoid sectors of the market that are lagging and could possibly continue on a downtrend. This proactive stance could lead to better preservation of capital during market downturns. The relative strength approach essentially filters out weaker performing allocations, thereby potentially reducing exposure to adverse market conditions.
POTENTIAL Downsides:
High Turnover
One significant drawback of the relative strength approach is its high turnover rate. As market conditions shift, portfolios may quickly move in and out of favor, necessitating frequent adjustments to align with the strategy. This constant churning between asset classes often leads to increased transaction costs due to buying and selling securities. Moreover, the high turnover rate may also trigger ordinary income and/or capital gains taxes.
Risk Objective Drift
The relative strength approach favors portfolios that are outperforming. This strategy, however, might result in an allocation that doesn't match a particular risk tolerance objective in certain market conditions. In a bullish market, for example, this strategy might favor stocks or other high-risk investments because they are performing well, potentially going beyond the level of risk acceptable by a conservative investor. In contrast, the relative strength approach may overly focus on lower-risk assets in bearish market conditions, which may not be suitable for an aggressive investor. Therefore, the relative strength approach may momentarily overlook a client's risk parameters in its pursuit of better performance.
Late Entry or Exit
The relative strength approach relies on past performance which may cause delays in reacting to market changes. A late entry into a rising portfolio or a delayed exit from a falling one can erode potential profits. This lag can hinder capitalizing on initial gains or avoiding early losses.
Potential Over-concentration
There's a risk of over-concentration in certain sectors or asset classes, particularly in extended bullish markets. This lack of diversification can expose the portfolio to additional risks when market tides change.
Reliance on Past Performance
The relative strength approach is rooted in analyzing past performance to predict future trends. However, past performance isn't always a reliable predictor for future results, especially during whipsaw market shifts.
In conclusion, the relative strength approach to selecting portfolios offers a blend of simplicity and potential performance enhancement. However, the accompanying high turnover and a few other drawbacks warrant a thorough consideration. As an investment advisor, blending this approach with other strategic elements, and a clear understanding of its mechanics, can be a step towards better risk-adjusted returns for your clients.
We invite iQUANT members to check out the new iQ Relative Strength of Portfolios (RSoP) Portfolio.