By Carlos M. Sera and Carl E. Sera, CMT
This paper’s subtitle is Follow the Leader for a good reason. It is the easiest way to remember stock asset class persistence. Stock markets exhibit asset class persistence. This means top performing asset classes will continue to perform well and poor performing asset classes will continue to perform poorly. Some call this momentum persistence, while others call it relative strength. We prefer the term persistence. Our paper entitled The Half Life of Stock Asset Class Persistence provides insight as to how long the persistence effect endures and our paper entitled The Problem with Stock Asset Class Persistence points out persistence’s limitations. Stock asset class persistence as a separate investment style, different from a value style, a growth style, a capitalization style or whatever other style an investor may use is worth exploring.
The one unequivocal requirement for the inclusion of persistence in a portfolio is that the persistent investor must be consistent or disciplined. A persistence style can be implemented in four ways; as a stand alone portfolio technique, in conjunction with risk management techniques, to complement an established portfolio as an investment style since persistence exhibits a low correlation with the stock market and as a focused style specific technique devoid of what some call style drift. This means that the persistent investor must be technically or quantitatively driven but as you will learn in our paper Selecting Assets to Trade in a Persistence Style has at its core a fundamentally component.
In order to include a persistence style in a portfolio an investor must know exactly what to expect. This paper and the series of papers that are linked to this paper explain an approach that is quantitative, disciplined and understandable. For the sake of simplicity, we will only use 3 major stock asset classes in this paper and try to limit it to these same three throughout. We will use Large Cap Domestic, Large Cap International and Small Cap Value. Specifically we will use the S&P 500 Index for Large Cap Domestic, The MSCI EAFE Index for Large Cap International and The Russell 2000 Value Index for Small Cap Value. We will use annual data to illustrate persistence in this paper however it is not the time frame that we recommend when managing portfolios. To begin, the first thing to understand about persistence is; Investing in last year’s asset class winner or leader is consistently a better investment than investing in a Buy and Hold strategy and far better than investing in last year’s asset class loser or laggard. In a Darwinian sense, money flows to the fittest asset class until a fitter class emerges.
As indicated earlier and as shown in the Appendix, we will use Large Cap Domestic, Large Cap International and Small Cap Value. Using just these three asset classes this paper analyzes every possible stock asset class combination for the 30 year period that ends in 2008 and tests for high positive momentum and low momentum. High positive momentum is The Leader. Low momentum is The Laggard. The Appendix shows the actual annual stock asset class rates of return for the 3 stock asset classes.
The following table entitled The Case for Persistence Investing shows the result of investing $5,000 in each of the 2 asset classes listed under the heading Stock Asset Classes and $3333.33 in the case where we have all 3 stock asset classes. We can see for example that in the case of the S&P 500 and EAFE, a $5,000 investment in each would have grown to $165,841 by the end of 2008. Under the heading Leader we can see what investing in last year’s leader or top performer would have returned and we can see that it is much better than the Buy and Hold strategy. Similarly under the heading Laggard we can see what investing in last year’s laggard or worst performer would have returned and we can see that it is much worse than the Buy and Hold strategy. In all 4 possible cases we observe high positive momentum and low momentum. We call this positive persistence and negative persistence.
The Case For Persistence Investing
Let’s refer to the Appendix to make sure the mechanics of how to trade in a persistent style is understood. It’s a ranking system. Let’s use the S&P 500 and EAFE as an example. We can see that the S&P 500 returned 18.61% in 1979 while the EAFE only returned 6.18%. Since 18.61% leads or is larger than 6.18% it gets a 1 ranking. The persistent investor would invest all their money in the S&P 500 for the year 1980 since it is ranked as 1. This turned out to be a good decision in 1980 because the S&P 500 once again outperformed the EAFE. The S&P 500 made 32.45% while EAFE only made 24.43%. So persistence would tell us to once again invest 100% of our money in the S&P500 for the year 1981. This didn’t turn out quite as well. In 1981, EAFE outperformed the S&P 500. The EAFE only lost 1.03% while the S&P 500 lost 4.93%. So for 1982, the persistent investor would switch from investing in the S&P 500 and invest 100% of their money in the EAFE since it was the top performer in 1981. This back and forth investing in the top performing asset class from the previous year goes on every year through 2008 and demonstrates persistence in action or the “how to” of stock asset class persistence.
This paper shows the results of investing in a 2 or 3 major stock asset class portfolio. It uses a Buy and Hold approach as a baseline and compares it to investing in last year’s Leader or last year’s Laggard. Clearly stock asset classes exhibit both positive persistence and negative persistence. Last year’s winner can predict this year’s most likely winner. Persistence of performance is not a new concept but a variation of a trend-following technique utilized by many of the world’s most successful investors. It is a disciplined approach to investing that can be implemented as a stand alone portfolio with or without style drift, as a hedged portfolio or as a complement to an existing portfolio.
(Annual Rates of Return for 3 Major Stock Asset Classes)