A PDF version of this commentary can be downloaded here.

Special Announcement

Newfound’s first quarter commentary is now available on our website and can be accessed here.

Market Thoughts

Those familiar with our Risk Managed Sector series (U.S. large-cap, U.S. small-cap, and global large-cap) know that we utilize an equal-weighting methodology among the sector ETFs we invest in. For example, when all 9 of the U.S. large-cap sectors are in the portfolio, they each receive an 11.11% allocation.

We use an equal-weight construction methodology for two reasons. First, it helps prevent over-allocation to bubbling sectors, like technology in the early 2000s and financials prior to the 2008 crisis.

Second, it allows our momentum signals to have an equal impact on portfolio construction. For example, the materials sector is currently about 3% of the S&P 500 while technology is over 21%. If we tracked these market-cap driven weights, the accuracy of our signal on materials would be more-or-less meaningless while the accuracy of our signal on technology would drive the vast majority of the portfolio’s performance.

So by taking an equal-weight approach, we can take advantage of diversification.

In the last six months, however, this equal weight approach has been a drag on portfolio performance, with an equal-weight large-cap portfolio underperforming the S&P 500 by 40 basis points (bps), an equal-weight small-cap portfolio underperforming the S&P 600 by 460bps, and an equal-weight global portfolio underperforming the MSCI ACWI by 152bps since 9/30/2014.

When confronted with this sort of scenario – a situation where strategic decisions are leading to consistent performance drag – we are going to want to analyze the process from both a statistical and fundamental standpoint.

Instead of drowning in statistical summaries, we can simply plot the relative performance of an equal-weight portfolio over time versus a standard benchmark.

Such a simple visualization will give us key insights into historical scenarios, volatility of relative performance, and the extent of the recent pullback.

Figure 1 – 2015-04-20 Figure 2 – 2015-04-20 Figure 3 – 2015-04-20

We can see a few things. First, from the early 2000s to sometime around 2010, equal sector weighting created fairly consistent outperformance against the benchmark. Post 2010, however, is a different story, with the equal-weight portfolio and the market-cap weighted benchmark more or less going sideways against one another.

So what has caused the recent underperformance? We can look under the hood to compare our relative sector over- and under-weights compared to their respective market-cap weighted benchmarks.

Figure 4 – 2015-04-20

What we can see is that, currently, an equal sector weight large-cap portfolio is largely overweight towards materials, energy, and utilities, while it is largely underweight financials and technology. The small-cap weights deviate even more significantly.

So what has happened since 9/30/2014?

Figure 5 – 2015-04-20

It should come as no surprise that those sectors the equal-weight portfolio is overweight have done the worst, and those that we are implicitly underweight have done the best.

In fact, on average, those sectors implicitly over-weighted in an equal sector weight U.S. large-cap portfolio had an average return of 3.09% while those implicitly under-weighted had an average return of 9.76%.

So should we reconsider our equal sector weighting methodology? From our perspective, we answer the question with a resounding “no.”

Taking a historical and statistical view, the sort of underperformance experienced in the last 6 months from these structural decisions is well within normal levels. Under the surface, large sector dispersion in a few key sectors was the primary driver.

At Newfound, our purpose of using an equal sector weight methodology is not to place a performance bet on those sectors we are implicitly over- or under-weight. Rather, we utilize an equal-weight methodology to ensure that our decision to tactically include or remove each sector within the portfolio has equal impact. While there are periods where this decision can serve as a headwind, historically there are just as many periods where it has served as a tailwind. While equal-weight has underperformed in the last 6 months, the next six may be just the opposite.

In Our Models

We rebalanced our Multi-Asset Income portfolio this week. We added to our positions in bank loans and the S&P 500 BuyWrite portfolio while reducing our exposure to mortgage REITs and corporate bonds. We also trimmed positions in long-term Treasuries, domestic and international REITs, and dividend stocks.

Our momentum signal on bank loans continues to oscillate between positive and negative. We believe the inconsistency highlights the importance of our tranching system in helping control whipsaw. If the signal for bank loans were consistently positive, we expect it would comprise nearly 18% of the portfolio. An un-tranched portfolio, therefore, would be subject to large whipsaw and trading costs from adding and removing the position in subsequent weeks.

Tranching, which will effectively evaluate the consistency of the signal over the prior 4 weeks, has helped us more slowly build our position as the model waits for consistency in the signal.

Corey is co-founder and Chief Investment Officer of Newfound Research, a quantitative asset manager offering a suite of separately managed accounts and mutual funds. At Newfound, Corey is responsible for portfolio management, investment research, strategy development, and communication of the firm's views to clients. Prior to offering asset management services, Newfound licensed research from the quantitative investment models developed by Corey. At peak, this research helped steer the tactical allocation decisions for upwards of $10bn. Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University. You can connect with Corey on LinkedIn or Twitter.