Proactive Advisor Magazine v07-06-Patricia Cathey : Page 5

“And in this corner, the master of momentum, the man who put the ‘T’ in Turtle, we have Richard ‘Breakout’ Dennis! And in the other corner, the ruler of reversion, Larry ‘Buy the Bounce’ Connors!” ing, Ding, Ding! As the fighters begin dancing around the ring, the tuxedoed announcer reviews their impressive re-cords: “Richard Dennis and his so-called Turtle disciples have been prime examples of mo-mentum investing since the 1980s. Dennis is said to have turned $400 into tens of millions, and some of the Turtles have had incredible success stories of their own. His style might be summarized by the maxim, ‘The Trend is your Friend.’” “And what can we say about Larry Connors,” continues the announcer. “The challenger has distinguished himself with a ‘Buy when there is blood in the streets’ trading style, and with several books to his credit over the last 15 years, there is plenty of evidence to support his methods.” “Let’s get ready to ruuummmbbbllleee …” These “fighters” have championed their own unique versions of two popular types of active management approaches: price momentum and mean reversion. Yet, despite the apparent contradiction in styles, there are successful fund managers and investors who swear by both ap-proaches. How can that be? Let’s define both terms. Price momentum can be viewed simply as a period of increasing prices, either on an absolute or relative basis. Absolute momentum evaluates each invest-ment “one fighter at a time.” In contrast, rel-ative momentum weighs how a stock or index has performed in comparison to others. In both cases, momentum can cover a variety of time frames and asset classes including foreign exchange, bonds, commodities, stock indexes, and individual stocks. In this article, we’ll focus on absolute mid-term price (AMTP) momentum, using only stocks. In this context, we can define momentum using the most recent 3-to D 18-month (i.e., mid-term) change in stock prices. If prices are higher at the end of the period than at the beginning, there is positive momentum. Academic studies confirm that investments in strong performers over this period tend to continue to outperform the market in the following 1 to 12 months. In contrast, mean reversion is the tenden-cy for equities that have underperformed or outperformed to reverse course. For example, numerous publicly available strategies cap-italize on the tendency for “noisy markets” to reverse direction. Noisy markets are those where price, like our fighters, tend to dance around even as they trend in an overall direction. There are several categories of mean reversion—short-term and long-term, absolute, and relative. This article will discuss absolute, short-term price (ASTP) mean reversion. In ASTP mean reversion, poor performing markets, sectors, or stocks tend to bounce back. Let’s walk through the “tale of the tape” table to understand typical aspects of both strategies. Absolute, mid-term price momentum strategies buy a selection of stocks that have performed well over a period (the “formation period”)—often the past 3 to 18 months—hold them for a time—typically 1 to 12 months— and then repeat the process. Some versions also short the weak stocks, but our focus is on long-only portfolios. The reported win rate for momentum strategies varies; shorter formation and holding periods often result in lower win rates. But our experience evaluating client strategies shows AMTP momentum typically averages win rates from 40% to 60%. Momentum strategies work best in markets that trend efficiently. What is an efficiently trending market? These markets get from point A to point B in a relatively straight line; the straighter the line, the more efficient the market. As you might have guessed, momen-tum investors in U.S. securities have reaped significant profits during the bull market of the past six years. In contrast, ASTP mean reversion takes advantage of the noise, or choppiness, appar-ent in many markets. These strategies buy a selection of stocks that have performed poorly over the formation period, which is typically 2 to 20 days. Because the formation period is relatively short, the market information it relays is also seen as relatively immediate. As a result, securities are held briefly, just until they start to continue on pg. 13 Tale of the tape Attribute AMTP momentum “Buy the winners” ASTP mean reversion “Buy the losers” Formation period Holding period Win rate Trade frequency Buy Works best in 3 to 18 months 1 to 12 months Moderate (40% to 60%) Low (Monthly rebalancing) Strength Efficiently trending markets 2 to 20 days 1 to 15 days High to very high (60% to 90%) Moderate (3 to 7 trades per month) Weakness Noisy markets August 13, 2015 | 5

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