Factor Diversification
In creating portfolios, it is a common and even expected practice that you will diversify your exposure to different asset classes, market caps, sectors, etc. but diversifying factors is discussed much less frequently, so why can’t we think of using Relative Strength in a similar way? The idea is the same- add together assets and strategies that have different characteristics and are not perfectly correlated to create a portfolio that is greater than the sum of its parts.
In order for diversification to have the intended effect, we want to blend relative strength with factors that do not outperform or underperform the market at the same time. If we measure this by correlation of excess returns, momentum seems to pair well with several other factors, namely value and low volatility.
Momentum Vs. Growth
Traditionally, it has been common to blend together value and growth in the same portfolio, but if you look at their respective periods of outperformance and underperformance over time, you can see that doing this ends up being something of a zero-sum game.
Momentum, on the other had, has more frequent periods of outperformance and underperformance, but its ability to adjust leads to outperformance in the long run.
If you can access the return generating abilities of momentum but blend it with complementary factors to reduce the overall volatility, it may benefit your overall portfolio over time.
If the purpose of investing in “growth” companies is to drive long term returns in your portfolio, you may consider using momentum to fill the growth portion of your portfolio since it has shown to be effective at generating long-term outperformance and seems to pair better with value in helping your portfolio reach those long term goals.
Relative Strength in a Portfolio
Our research has shown that Relative Strength has the ability to generate long-term excess return, but a Relative Strength process needs to be applied consistently over a long period of time to give yourself the best chance of realizing the benefit of Relative Strength. With that in mind, there are a few things to consider with respect to incorporating Relative Strength into a portfolio
First, Relative Strength works best over long time horizons. Just as with any investment strategy, it will not outperform at all times, so it needs to be given time to do what it has been shown to do over long periods.
Also keep in mind that Relative Strength is meant to generate excess return. Other assets in your portfolio might be used for income or volatility reduction.
Relative Strength can be more volatile, which is why you may not want to devote your entire portfolio to Relative Strength based strategies, but for assets than can withstand more volatility, it may be appropriate.
If you want to alter a Relative Strength strategy to focus on finding value, you are likely looking for a value strategy in the first place. Don’t try to split the difference.
Add all of this up and it can help you develop a strategy for allocating to Relative Strength. Carve out a portion of your portfolio that is designed for long term capital appreciation and less sensitive to volatility and blend it with other factors designed to accomplish other portfolio goals and reduce overall volatility when combined with your Relative Strength sleeve.