Why it’s too late to buy out-performers

by | Nov 25, 2016 | All Articles, Technical Analysis, Education

We are told that “past performance is not a guarantee of future returns”. For many years now, regulators have mandated that every piece of advice have that statement attached. You would think it was the 11th commandment. Yet many advisers and investors will recommend the best performing securities based on that very assumption. I remember sitting with an advisor who pointed out all the funds and asset classes that had been performing the best. He suggested that I should be investing in those funds. Of course I trusted his advice at that time—he was the professional after all! My investments languished while other funds shined.

The second statement that people love to quote is “Buy Low – Sell High”. Trouble is, if we listen to the advice of someone who is focused on buying the best performing fund, we’re actually doing the opposite and buying high! “Hang on!”—you may be thinking—“Surely the fund will keep out-performing?”. Well….no. To answer this, I need to explain a bit about RRGs.

Buy Low - Sell High

As part of our research into Relative Rotation Graphs (RRG®), we knew the best RRGs were those in which all the securities on the chart were fully included in the benchmark. For example, when we use the ten GICS S&P500 sectors with the S&P500 as the benchmark, we know there are no outside influences on the benchmark. The benchmark is fully described by all the securities that are on our RRG.

Stop Press

If you aren’t familiar with RRGs, you can watch this 35min webinar that I recently presented. You will learn how RRGs can be used for stock selection and portfolio management here http://oab.io/vyaje

Why is this so important? What we want to see is balance in the RRG. We want to see an equal distribution of the securities around each axis on the chart. Stay with me. I know this is getting theoretical, but it is getting somewhere good. I cover this, and the importance of Cap Weights, in a lot more detail in the RRG Weights research paper at
http://www.optuma.com/research

If we were to put a thousand ETFs into an RRG, what should we use as the benchmark? The S&P500 would not make sense since it’s an equity index and the ETFs may represent a mix of asset classes. To solve this situation, we created automatic Price Weighted and Cap Weighted benchmark options. This allows us to test the thousand ETFs against the average of all the ETFs that we added to the chart.

Ok, back to the issue with the funds. Remember that I’m trying to show you that the traditional advice of buying the out-performer is like getting to the party when it’s almost over. I hate that! What we noticed was when looked at the ETFs on an RRG compared to their average, is that they still went through the RRG cycle of Leading to Weakening to Lagging to Improving. The following image is of the thousand ETFs on a RRG with a Price Weighted Average. While it’s very messy, you can see the tails (where the securities have been on the chart) are showing the history of the clockwise rotation.

This shows us that we could take a fund that is underperforming the market—but showing some relative strength—and have a high level of certainty that it will rotate to outperform the market. What’s even more important is that it proves that a fund that has been outperforming the market has a much higher risk of weakening and then lagging. Below, you can see from our tests of over 20,000 rotations, that there’s a 92% probability that a security that’s Leading will rotate into Weakening.

Current QuadrantMoves To LeadingMoves To WeakeningMoves To LaggingMoves To Improving
Leading-92%4%4%
Weakening38%-62%0%
Lagging5%5%-90%
Improving68%0%32%-

Don’t buy the outperformer! Not only is its past performance not an indicator of future success, but it has a 92% probability of being the exact opposite! We need to be finding the securities that have the highest probability of gain, not the highest probability of underperforming.

Again, this is exactly what the RRG can do for us. It allows us to identify securities that have been underperforming the benchmark but are showing relative improvement. In fact I’ve had two Portfolio Managers email me after I presented the RRG webinar. They both shared with me how RRGs have helped them significantly in their process. By using RRGs, they’ve been able to consistently out-perform the market.

Using the Signal Tester, we were able to do a lot of quantitative testing of this idea. You can read all about that in the extended version of this blog post at http://www.optuma.com/research Look for the paper called Buying out-performers is too late.

Warning!

Warning Remember that RRGs are a “relative” measure. That means when the benchmark is going down, any security going down more slowly will be considered to be outperforming the benchmark. It’s outperforming, but still losing money. If you can further filter your strategy to periods when the benchmark is trending up, then you’ll have an awesome strategy. One idea is to use volatility swings. See Want to know a better way to determine trend? In a similar way, just because a fund is under-performing the benchmark does not mean we are losing money. It’s just that there are better funds that will perform even better.

The bottom line is the results show us that the best time to invest is when a security has been underperforming and is just starting to show signs of strength. Doing so allows us to Buy Low and Sell High. This gives us a technical way to employ the Buffett methodology of buying when everyone else is selling.

Next time I’ll discuss the various roles that I’ve identified in the investment industry, and use them to explain why Relative Strategies are critically important for everyone to be aware of. We’ll also explore why relative strength has a high probability of leading to absolute returns.

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Mathew Verdouw, CMT, CFTe

Mathew Verdouw, CMT, CFTe

CEO / Founder Optuma

As a Computer Systems Engineer, Mathew started Market Analyst (now Optuma) within 18 months of completing his degree. From that point on, Mathew has made it his mission to build the very best software tools available.

Since 1996 Mathew has been learning about all aspects of financial analysis, and in 2014 earned the CMT designation (Chartered Market Technician). In 2015, he was also awarded the CFTe designation. As someone who has dedicated his life to find better ways to analyse financial markets, Mathew is set to drive innovation in this sector for many years to come.

2 Comments

  1. This is great how how do you access RRG , I have looked and cant find them. Do you need add ons or different data / software? This is why going to the GYM is so Hard.

    Reply
    • Mathew Verdouw, CMT, CFTe

      Hi Cam,

      So long as you have an active Trader Services subscription with Optuma (for data and support) it is included in that. Goto “New” then “Multi-Code Chart” then “Relative Rotation Chart”. Have a look at the webinar that I did on RRGs at http://oab.io/vyaje

      Reply

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