July 5, 2011
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In 2002 and 2008 the investment tide went out. And as Warren Buffett famously predicted, we learned who was swimming naked. Both times, it was the practitioners of Modern Portfolio Theory (MPT).
After getting hammered twice and experiencing a lost decade, investors are now clamoring for a different approach. They want the investing version of the Holy Grail — protection from large losses with attractive returns in an up market.
Tactical asset allocation (TAA) is such an approach. TAA can encompass a number of different approaches. At our firm, we combine four different tactical approaches in client portfolios:
Trends: Buy an asset when the trend is up and sell it when the trend reverses
Short-term counter trends: Buy into weakness and sell into strength over the short term
Inter-market analysis: Use one market to predict the movements of another
Momentum: Buy the top-performing markets or sectors
Most advisors will quickly dismiss a pure tactical strategy, fearing that its execution is too difficult or that they will be mislabeled as market timers. But in doing so, they miss out on capturing one of the most significant sources of excess return — momentum, which is the focus of this paper.
Momentum is the documented tendency of investments to persist in their performance. Stock and bond sectors that outperformed other sectors during a period of time (one month, three months, six months, etc.) tend to continue to outperform. More than 300 academic papers have been published showing that momentum outperformance exists in just about every asset class.
If momentum is such a great strategy, then why aren’t more people using it? Think back a few hundred years, when it was official church doctrine that the Sun and planets orbited around the Earth. That was not considered theory — it was taught as fact. Any other idea, no matter how well supported, was heresy. That is the state of the financial services industry today. It has so much invested in the idea of MPT that if it were proven that it didn’t work, such evidence would be devastating.
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