Why Relative Strength?
The answer to why we focus on Relative Strength is actually pretty simple- it has been shown the ability to produce returns above the return of the market when applied consistently over long periods. In addition to performance, there are a few other benefits we think it offers your investment process.
We believe Relative Strength is very adaptive in nature, which allows us to adjust our portfolio to remain suitably allocated based on the current market environment and capture new trends as they develop. This also means it is not reliant on the same types of companies or market segments outperforming at all times.
Relative Strength is also simple in concept, but powerful in its application. Since Relative Strength is simply the comparison of price performance within a universe of securities, it is not difficult to develop a rules-based system for investing in high Relative Strength securities. However, since research has shown it to be applicable across a variety of markets and security types, it is a very valuable portfolio management tool.
Relative Strength’s ability to deliver outperformance has been demonstrated by numerous academic and financial studies over the years, which have shown that the momentum phenomenon exists both across different markets and asset classes as well as within individual markets and asset classes, allowing you to benefit from incorporating Relative Strength throughout your investment process, from developing an asset allocation to selecting the securities that fill out that allocation.
Relative Strength for Asset Allocation
As shown below, allocating to the top asset class based on Relative Strength performs best over time, which underscores the benefit of using relative strength to help adapt your allocation based on market conditions.
Relative Strength for Sector Rotation
Relative Strength has also shown to be effective at delivering outperformance via sector rotation with a strategy built on buying the top performing sector at any time outperforming the market and a strategy of buying underperforming sectors leading to significant underperformance over time.
Relative Strength for Security Selection
Many studies have shown that securities with the highest Relative Strength tend to perform best over time. This graph shows a universe of securities ranked in terms of Relative Strength and split into deciles. The top 10% in terms of Relative Strength end up outperforming each of the other deciles over time, and the bottom 10% underperform significantly.
In addition to high Relative Strength stocks being shown to outperform low Relative Strength stocks, research has also shown that high Relative Strength stocks can outperform the stock market as a whole over long periods. This really emphasizes why we believe Relative Strength can be a valuable component in any investment process. Focusing on strength gives you a straightforward method by which to generate outperformance in your portfolio, and its effectiveness in comparing asset classes, sectors, and individual securities makes it useful in a number of different stages of a portfolio construction process.