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For the sake of clarity, my confession of fallibility is in reference to an article titled "Passive Momentum Asset Allocation, Putting The Market To Work For You," which appeared in the Journal of Indexes First Quarter 2004 issue, on pages 36-39. It is page 39 that will be receiving most of our attention, and in particular, the comments and findings on that page regarding sectors. So now that I have come to you all and bared my manager's soul and publicly admitted my error, please allow me to at least defend those portions of the offending material that I still stand foursquare behind, before I delve into the bothersome mistakes. Thank you. First, there is this comment on our passive momentum model: "While we were pleased that the model was successful at some level with sectors, we could not justify any practical utilization, given the negative factors outlined and the lack of return premium." This statement is as true today as it was when the aforementioned article was originally published . Any momentum scheme that is based on a time period of less than a year is susceptible to a number of significant negatives. It is our observation that short-term variations of positive or negative momentum are in effect chaotic and resemble random noise. This will of course tend to produce random and chaotic returns, which are far from random in how they subject clients to volatility. Secondly, the tax consequences of any short-term momentum trading theory (which produces positive returns) must (in most cases) be negative. Moreover, there is the problemof the excessive expense generated by excessive trading. Please allow me to stray just a bit here. My second point, that the tax consequences of the rare successful short-term momentum trading scheme can be a negative, brings me to a currently popular phrase in the money management business, "loss harvesting." Since it is my experience that most momentum plans produce losses, those who champion this whole idea of loss harvesting would applaud such a practice. In my opinion, the spin doctor who coined the loss harvesting phrase puts all those practicing the art (?) of spin in politics to shame. As a manager, I want at all costs to avoid losses in my clients' accounts, even if we attempt make them sound painless and fruitful by "harvesting" them. I like gains; losses - whether "harvested" or left in the field to rot - I do not. Go to page 39. The other issue I'd like to defend is the notion that "sector" and "asset class" are not interchangeable terms. This is a situation those of us in the trenches of real world portfolio management do face. I will still support the notion that sectors tend to muddy the waters when viewed through the lens of the Fama and French (JIM: IS THIS RIGHT? Not everyone will know - top of mind - what the Three factor Model is. You might ask Silver if we can insert this information, or how he would define it.) Three Factor Model, that famous asset pricing model that ascribes higher risks to small capitalization stocks and stocks with high book-to-market-value ratios . There can be no arguing that any sector will encompass stocks that cross the various boundaries of the Three Factor model -clearly, market cap and book-to-market ratios are in no way used to define any sector I am aware of (bloggers, come get me if you can). But since this is intended to be a full disclosure piece, when those Three Factor Model lenses are removed sectors are certainly a valid portfolio designation. Three Factor or not, a sensible momentum discipline can be profitably applied to sector investing. And indexing is the key. That seems to be about as much of my original observations on sectors that I can defend. Let's get on to what may be the most egregious oversight and get it out of the way first. And why none of you bloggers got this escapes me… Error #1:"…we haven't found any sector product that is passively managed." Technically, this is actually an accurate statement; we hadn't found such a product at the time. Of course, such a product exists now and it existed then, but we hadn't found it. Obviously, we didn't look very hard. As I will attempt to show in the remaining space available, the utilization of index sector ETF's (I will be using the iShare/Dow Jones family of products) allows for the successful implementation of an index-based approach to passive momentum investing. Our original study, performed in 2001, as outlined on that now (in)famous page 39, was loaded with problems. From a passive manager or an investor's point of view, the single most offensive problem was the use of actively managed funds from the Fidelity family. I have no particular argument with Fidelity - we use them (sparingly) as a broker in our practice - but at the time, their sector funds seemed the only game in town. It is my belief that the inherent failings of most active managers lies at the root of this abandoned experiment. Too much trading in the portfolios, which is likely impacted by the vagaries of short-term momentum (as well as other factors), surely led to too many incorrect choices within the fund portfolios. This resulted in unacceptably inconsistent annual returns, which I believe are the result of losing touch with long-term positive momentum, and forced the sector study to seek positive results from short-term trading horizons, with the expected sorry results. All of which doesn't even touch on the issue that upsets so many fund investors, pass-through capital gains. Error #2: "…..ETF's have far more appeal than do actively managed product, although you will run into the same issues in terms of trading the fund(s)….." Again, I will make a modest defense that the above statement is at least partially true. ETFs certainly did and do have far more appeal than do actively traded funds. I don't think I need to rehash all the reasons that index products are more efficient and desirable investment vehicles than actively managed funds in any well thought out portfolio or investment policy. But as I will show, you really don't have to succumb to the inherently fatal flaws of an actively managed sector allocation just to pursue a momentum approach. Where I was as wrong as wrong can be is that with ETF's, you needn't suffer the same costly and inefficient fate befell the actively managed strategy in our original 2001 study. So why, with the obvious shortcomings of an actively managed fund-based approach, didn't we seek out the ETF's back in 200? I could blame it on sponsors for not making enough noise so that we managers might have had a better understanding of the product. But that wouldn't be true for me. The truth is, as outlined again on page 39, we were so put off by the lack of an international Three Factor Model ETF product (a deficiency which, I have been told by some highly placed and reliable sources, is being looked into, with possible resolution actually coming to market in the reasonable future), and our own belief in the Three Factor Model for other portions of our practice, that we just overlooked the entire genre. As I told you at the very beginning, mea culpa. We still hold that the Three Factor Model is a superior way to categorize the markets, and continue to manage our clients' funds with the model clearly in our crosshairs. But we are also believers that Adam Smith got it right when he focused attention on the power of supply and demand on markets. The extraordinary growth of the supply of ETF's has certainly drawn our attention, and this must be a factor of the demand for the product. Given that, and our original observation that ETF's are a superior product as compared to actively managed mutual funds, it is time to revisit the sector momentum issue in light of these funds.. The momentum I cite can be well understood by reviewing the article cited above, "Passive Momentum Asset Allocation, Putting The Market To Work For You," in the Journal of Indexes, First Quarter 2004, pgs. 36-39. In a nutshell, I can also outline Passive Momentum Asset Allocation® (PMAA) here, and note that all the data that follows is based on following the PMAA discipline. PMAA is based on the discovery that the advantages to a portfolio from momentum can best be utilized using an annual reallocation time horizon, ignoring short-term momentum swings and owning half of the designated universe. More detail on PMAA can be found in two other articles (King, Silver, Guo, "Passive Momentum Asset Allocation," Journal of Wealth Management, Winter 2002, pp.34-41, and King, Guo, "Tax Efficient Passive Momentum Asset Allocation," Journal of Wealth Management, Summer 2003, pp.68.72), neither of which contains any of the errors of JOI pg. 39, as the issues of sectors and ETF's were not addressed. Our universe for this new sector study utilized only iShare Dow Jones domestic products, an issue that bloggers may feel free to challenge. The sectors we used to construct our model are: Basic Materials (IYM), Consumer Cyclical (IYC) Consumer Non Cyclical (IYK) U.S. Energy (IYE) U.S. Financial (IYF) U.S. Health Care (IYH) U.S. Industrial (IYJ) U.S. Real Estate (IYR) U.S. Technology (IYW) U.S. Telecommunications (IYZ) U.S. Utilities (IDU). The most compelling factor that contributed to a sector's inclusion was a minimum ten-year available track record for the underlying index. And it should be noted that all the data used here is from sources supplied by iShares and Dow Jones. None of the returns we will exhibit in the model portfolio are of any of the above-cited ETF's, but rather from index returns themselves. Tracking error and fund expenses are not accounted for.
The chart label Ranked Sectors is a good place to start. This data represents what we have called the persistence of momentum. Each sector ranking represents the performance of a prior year's sector performance (by rank) in what we refer to as the ownership year (JIM: Confusing - is this made clear in the chart?). It can be seen that over time (in this case an 11-year period) the results support the proposition that long-term momentum, while not as flashy as the short-term variety, can be very healthy for a sector portfolio. I think it is important to point out that while I have no specific data to support the following contention, I believe that much of this persistence is the result of the hands-off approach of indexes as opposed to actively managed sector (or any other type) portfolios. Our earlier work has taught us that short-term momentum is really quiet fickle, random and elusive to capture in a utilitarian fashion. Even the best of active managers (and yes, I will stipulate that there are good ones out there) are often misled by short-term momentum. But it has been our observation and contention that indexes - by leaving things to the actual workings of the market itself - will tend to account for the vagaries of short-term momentum and the volatility it causes over time. In a practical sense, we need to take the data another step. How might an actual (for purposes of this article all data is in fact historical and hypothetical) portfolio of sector indexes be constructed and expected to perform? It has been our experience that in an effort to most honestly look at backtested material, the allocations within those tests must be of equal dollar weight. With 20/20 hindsight, it would be easy to allocate more assets to better-performing sectors and skew the results. It is also how we manage assets in the real world, since no one has 20/20 foresight.
The data in the Adding Sectors Chart holds no real surprises. Adding sectors will lower the overall return, but has the advantage of alleviating volatility (as measured by standard deviation). There is clearly added benefit to eliminating sectors from a portfolio on an annual basis, as it is clear that the diminished volatility of owning all sectors in the sample is too costly (in our opinion) a price to pay for the diminished reutrn. Where along the arc of return and volatility an investor would be most comfortable is an individual choice. Our experience in the cauldron of actual portfolio management and client relations suggests that some level of sector diversification is called for, and full disclosure of expected returns and volatility is a must. There is no "right" allocation, only an allocation with which investor and advisor can align expectations. Implications And Summary The most apparent implication of our work here is that, once again, the stability and market sensitivity of indexes, be they grouped in a Three Factor Model priority or, as we have attempted to show here, in a sector model, will best serve investors. This superior service is also evident if a long-term momentum discipline is used to create and maintain a portfolio of sector indexes. I restate that our data here can be recreated in real portfolios using iShare/Dow Jones sectors or using other products to an individual investor's liking, but that our results and data are reflections of the iShare/Dow Jones product. Another implication that I think is very significant is the proof that diversification in and of itself has limited benefit to a portfolio designed with long-term momentum as a basis. As we see in our second exhibit, the more diversification, the lower the return. There is a point along the arc that will suffice for most investors that is well short of the need to own all sectors at a single time. Diversification up to a point is beneficial, in particular as it eases investor discomfort associated with volatility, but beyond that it would seem to have negative implications. We give no weight or significance to any individual sector. Each is allocated to our model exclusively based on its prior year ranking in the sample. Perhaps the implication that is the most unnerving for many investors is one that we draw from our first exhibit of the Ranked Sectors. It is our belief that this data suggests that the old saw of "buy low, sell high," needs a little revising. Buying anything low is of course ideal; determining when "low" is "low" is a real problem. What we think our data may best suggest is that an investor should hold high - it will serve them better - until the sector (in this model) for whatever reason reverses its course from positive to negative momentum. In summary, back in 2001 we missed the power of ETFs to propel a sector strategy based on our unique momentum discipline. The fact that there are index-based ETFs in the sector space, coupled with ETFs' inherent cost and tax efficiency, make these asset classes prime targets for momentum-based strategies. Because ETFs lend themselves so well to a prudent momentum program, we have now entered the space with enthusiasm.
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Mea culpa. I was mistaken. . . There, I said it. And now, thanks to an enlightened editor, I get the opportunity to set matters right. Now I will respond to the reading public and various nettlesome bloggers. 
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