F E AT U R E
Relative Strength
A Critical Portfolio Management Tool
By M i c h a e l M o o dy, CM T
R
elative strength may be the single most powerful and
adaptable tool available to the typical investment
advisor to help manage client accounts. Relative
strength should be in the toolbox of every investment advisor,
whether they manage accounts directly or help clients select
managers and construct portfolios. Unfortunately, it is
probably also the most misunderstoodand often incorrectly
malignedinvestment approach.
In this article I dene relative strength, describe how rela-
tive strength operates, and show how relative strength can
be used in practical portfolio management. I also discuss its
relationship to other strategies and its use in portfolio con-
struction and asset allocation.
Definition
Relative strength is measurement of performance relative to
a benchmark or to the rest of the universe. Relative strength
can be used to nd the strongest trends in a market or to
identify the strongest asset classes in a given universe.
Dispelling the Momentum Myth
Some advisors know this tool by another name. Relative
strength is the original name, coined by technical market
analysts sometime before 1900. But academics who belatedly
discovered relative strength in the 1990s renamed it momen-
tum. In this article, relative strength and momentum are used
interchangeably.
Momentum has acquired a bad rap. For many advisors, it
brings to mind the portfolio manager as fast-trading gun-
slinger. But relative strength (aka momentum) is nothing
like that. Its considerably more sophisticated: It involves
more than buying a handful of hot stocks. It is a disciplined,
systematic investing style that applies across asset classes
(Moskowitz 2010).
Momentum is really a misnomer. There is no direct rela-
tionship with what a physicist would think of as momentum.
Its more a giveaway to the physics envy that crops up repeat-
edly in nance and economics. Relative strength is a rate of
change over some time frame, as opposed to momentum,
which in classical mechanics is the quantity of motion dened
by mass times velocity.
Regardless, academic citations on relative strength will be
found under the term momentum. These academic citations
1
on relative strength aka momentum are now voluminous
18 Investments&Wealth MONITOR
2012 Investment Management Consultants Association. Reprint with permission only.
I&WM JanFeb2012 Blueline.indd 18
more than 300 papers by one countbut relative strength/
momentum still is misunderstood. Despite tremendous per-
formance metrics that exceed both value and growth styles,
relative strength/momentum gets overlooked:
Academics have been studying momentum investing
for the better part of two decades. As a stand-alone
investment strategy, it delivers positive abnormal returns
(alpha) above the markets returns, producing even better
abnormal performance than either size or value styles.
Momentums eect exists in nearly all securities, sectors,
international markets, and dierent asset classes. It
works in large-cap, mid-cap, and small-cap stocks and
among value and growth stocks, too (Moskowitz 2010).
That leads directly to another useful characteristic we will
discuss shortly, the universality of relative strength. In the
meantime, we have another question to answer: Why does
relative strength work at all?
Why Does Relative Strength Work?
Several theories have been advanced about why relative
strength performs well. Ecient market theorists originally
contended that additional returns were the result of the
strategy taking on additional risk, but subsequent papers have
demolished that argument:
To examine whether cross-sectional dierences in risk
explain momentum prots, a number of studies examine
risk adjusted returns under specic asset pricing models.
[Jegadeesh and Titman] (1993) adjust for risk using
the CAPM benchmark, and Fama and French (1996),
Grundy and Martin (2001) and Jegadeesh and Titman
(2001) adjust for risk using the Fama-French three-factor
model benchmark. In each of these cases, the alphas
of the momentum strategy are signicantly positive,
suggesting that cross-sectional dierences in risk do not
explain momentum prots (Jegadeesh and Titman 2011).
The leading explanations at this time are behavioral,
although there is no clear consensus on what behavioral expla-
nation should be preferred. According to Jegadeesh and Titman
(2011): the evidence suggests that momentum prots arise
because of a delayed reaction to rm specic information.
1/31/12 1:53 PM

FIGURE 1: PSYCHOLOGICAL STRATEGY SPECTRUM
Contrary to the ecient markets hypothesis, investors tend
to overreact and underreact to certain kinds of information.
Value investors, for example, often argue that investors overre-
act to negative information, leading to prices that are too low
given the fundamentals. Relative strength seems to suggest
that investors underreact to positive information, again lead-
ing to prices that are too low given the fundamentals.
In practice, both relative strength and value oer oppor-
tunities to be horribly wrong on individual securities. With a
value investor, it takes the form of a value trap, a cheap stock
that just keeps getting cheaper. With a relative strength inves-
tor, the nightmare is buying a strong stock that immediately
becomes weak. From a psychological standpoint, individuals
do not like situations in which incorrect decisions are bla-
tantly obvious. Individuals thus are motivated to stay in the
middle of the herd where they can fail conventionally.
Value and relative strength therefore oer psychological
arbitrage opportunitiesjust at opposite ends of the strategy
spectrum (see gure 1). This may be another reason why
value and relative strength combine well together in a portfo-
lio, a topic we will revisit later.
Universality of Relative Strength
For the investment manager faced with the practical task of
managing client accounts, one of the greatest benets of rela-
tive strength analysis is its universality. To operate eectively,
relative strength requires only dispersion of returns within
a universe. That makes it easy to apply to equity markets,
for example, where the returns from the best performers
and the worst performers are typically far apart. It is equally
useful in tactical asset allocation, where a broad universe of
asset classes may have signicant return dispersion. When a
universe has a very narrow performance spread between indi-
vidual itemsthink investment-grade bonds as an example
relative strength is not likely to work well.
Another useful attribute is relative strengths ability to
apply a universal yardstick across a broad range of asset
classes. In this way, it sets itself apart from many other invest-
2012 Investment Management Consultants Association. Reprint with permission only.
I&WM JanFeb2012 Blueline.indd 19
F E AT U R E
ment methodologies in ease of use. Tried-and-true value
investing has a relatively easy time determining what is cheap
and what is expensive in a single market such as domestic
equities. With a little more accounting work, valuations
can be compared across domestic and various international
markets. When it comes to comparing domestic equities and
commodity or foreign-exchange markets though, valuation is
more problematic.
Its much trickier to determine if IBM, natural gas, gold,
wheat, or the Aussie dollar is most attractive in the absence of
cash ows for some assetsand for the absolute lack of any
comparative metrics between assets. With relative strength,
on the other hand, it is a trivial matter to calculate trailing six-
month performance for even wildly disparate assets.
This attribute makes relative strength a compelling choice
for global tactical asset allocation, because most small rms
do not have the data and manpower to construct and update
valuation and expected return spreadsheets for dozens of
exotic asset classes.
The Sweet Spot for Relative Strength
Relative strength, like value, is a robust method. Value works
across a broad range of parameters, whether the analyst is
looking at low price to book, price to cash ow, price to earn-
ings, or price to revenues. Likewise, relative strength works
across a broad range of measurements.
Portfolios can be formed by measurement of six-month
trailing returns, nine-month trailing returns, 12-month trail-
ing returns, the relationship of a 65-day and 150-day moving
average, front-weighted four-quarter trailing returns, and many
other methodsthese are just a few that have appeared in the
literature. All of these measurement methods are capable of
outperforming the market benchmark over time.
Selecting securities on the basis of short-term relative
strength, however, results in poor performance. For example,
forming portfolios on the basis of trailing one-month perfor-
mance results in signicant underperformance. To be useful,
relative strength must be measured over an intermediate time
frame. Short-term measurements capture primarily noise
while very long-term measurements have a tendency toward
mean reversion.
The sweet spot for relative strength portfolio formation in
the equity market tends to be in the 612 month area. Table 1
shows returns from a range of published factors (Lewis 2011).
All of the intermediate-term factors outperform the market
over time, even when subjected to rigorous Monte Carlo
testing.
One common misunderstanding about relative strength
relates to the measurement of the portfolio formation period.
I wouldnt mention it except for the fact that we have received
numerous questions about it since Lewis (2011) was published.
When the table indicates that nine-month trailing returns
January/February 2012 19
1/31/12 1:53 PM
 F E AT U R E

TABLE 1: FACTOR SUMMARY (ANNUALIZED RETURNS FROM DECEMBER 29, 1995DECEMBER 31, 2010)
RS Lookback Period hidgs Avg* Max* Min* Index* % Outperf Est Turn
1-Month Price Lookback 50 4.1% 7.0% 1.2% 4.9% 22% 1384.2%
3-Month Price Lookback 50 8.6% 11.4% 6.0% 4.9% 100% 564.3%
6-Month Price Lookback 50 12.7% 16.6% 9.4% 4.9% 100% 303.4%
9-Month Price Lookback 50 12.5% 14.6% 9.8% 4.9% 100% 209.5%
12-Month Price Lookback 50 9.9% 14.0% 6.2% 4.9% 100% 157.5%
18-Month Price Lookback 50 7.3% 11.6% 4.0% 4.9% 95% 108.7%
2-Year Price Lookback 50 7.1% 10.0% 4.0% 4.9% 96% 88.2%
3-Year Price Lookback 50 5.5% 8.4% 2.7% 4.9% 74% 57.8%
5-Year Price Lookback 50 5.1% 7.8% 2.0% 4.9% 51% 51.0%
*Annualized Returns

are being measured to rank securities, various commercial services can be

FIGURE 2: DWA EQUITY RANKS
some readers make the assumption that used. The two most broadly distrib-
outperformance will last for only nine uted commercial services are probably
months. In fact, the outperformance of Dorsey, Wright & Associates (DWA)
any given security selected is not a given. and Investors Business Daily (IBD).
Outperformance may last for only a short DWA ranks relative strength for
period, for a period of much longer than individual equities on a 05 scale (see
nine months, or may not occur at all. gure 2) and oers pre-built relative
As with any security selection method, strength matrixes for asset classes and
plenty of selections dont work out at all. sectors (see gure 3). Relative strength
Another surprise for many invest- rankings for the mutual fund and
ment managers unfamiliar with relative exchange-traded fund universes are
strength is the moderate level of turn-
over of many measurement methods. FIGURE 3: DWA DJ-30 MATRIX
Several factors in the literature show
turnover below that of the average
domestic equity mutual fund (130-per-
cent annually according to Morningstar).
Relative strength can be used as a
stand-alone method of portfolio man-
agement or as part of a blended strategy
for portfolio construction.

Relative Strength
Portfolio Management
Using relative strength to manage a
portfolio is conceptually simple, but it is
dicult to execute in practice. Relative
strength rankings are best used along
with a casting-out process. First sort
your universe of securities by relative
strength; the relative strength rank-
ing method is a matter of personal
preference. Many dierent measure-
ment ideas are available in the relative
strength literature.
The rankings can be based on a
database of price data or rankings from

20 Investments&Wealth MONITOR

2012 Investment Management Consultants Association. Reprint with permission only.

I&WM JanFeb2012 Blueline.indd 20 1/31/12 1:53 PM


FIGURE 4: IBD COMPOSITE RANKS
done on a similar 06 scale. Users also
can construct custom relative strength
matrixes (not shown).
Investors Business Daily ranks
securities on their trailing four-quarter
return, with the most recent quarter
double-weighted in 40202020 fash-
ion (see gure 4).
Once the securities are ranked, a
portfolio is selected from among the
highest relative strength stocks. A com-
mon practice is to build the portfolio
from securities in the top quartile or
top quintile of relative strength ranks.
The casting-out process becomes
operative when a security falls suf-
FIGURE 5: ADDING MOMENTUM TO A VALUE-FOCUSED PORTFOLIO
2012 Investment Management Consultants Association. Reprint with permission only.
I&WM JanFeb2012 Blueline.indd 21
ciently in rank to become ineligible
for the portfolio. For example, if the
security falls out of the top half or top
two-thirds of the relative strength ranks,
it would be removed from the portfolio
and replaced with the highest-ranked
security that was not already owned.
Other renements can be added by sort-
ing securities into sectors or asset class
baskets, so that the security added
although still highly rankedwould
be what was required for purposes of
sector or asset class diversication.
With such a simple process, what
could possibly go wrong? In practice, we
have seen two major issues. One issue
is psychological; the other is inherent in
the relative strength method.
Drawbacks of Relative Strength
All methods that generate excess
returns go rogue from time to time.
The better the excess returns, the worse
things seem to get when the strategy
goes o the rails. This is the nancial
equivalent of contending that strang-
ers have the best candy, but there it is.
Relative strength is no exception.
When markets are trending steadily
or adjusting course gradually, relative
strength tends to perform quite well.
However, during periods of abrupt trend
F E AT U R E
change relative strength will lag, some-
times signicantly. Relative strength is,
after all, a trend-following strategy and
requires a period of adaptation to get
synchronized with a new trend. Thats
the inherent part of the problem.
The psychological pitfall is this:
During periods of duress a relative
strength investor is most likely to aban-
don ship and miss the smooth sailing
that may follow. There are really only
two ways to cope with dicult periods
in a strategy: 1) stick with the discipline
and ride it out, or 2) use multiple strate-
gies to diversify.
The idea of using multiple strate-
gies to diversify leads us directly to our
next topic: using relative strength in a
broader portfolio context.
Relative Strength Portfolio
Construction
Relative strength and value are stra-
tegic opposites. Relative strength is a
trend-continuation bet, while the value
investor is betting that mean reversion
will occur. Its not surprising, then, that
excess returns from the two strategies
are uncorrelated (Moskowitz 2010;
Berger et al. 2009). In other words,
years when relative strength performs
better than the market are years when
January/February 2012 21
1/31/12 1:53 PM
 F E AT U R E
value tends to lag. Years when value
outperforms tend to be lagging years
for relative strength. Thus, combining
the two strategies to create core equity
exposure is highly recommended (see
gure 5).
Because relative strength is a
growth factor and because it tends
to outperform growth over time, a
more-ecient portfolio with a higher
expected return can be built by sub-
stituting relative strength for growth
entirely. Thus, the ideal blend for core
equity exposure would match up a
relative strength manager with a value
manager (Berger et al. 2009).
Summary
Relative strength should be in the
toolbox of every investment advisor.
Academic research shows that it has
provided better historical returns in
the equity market than either size or
value styles. It is conceptually simple
and can adapt easily to a wide variety
IMCA Educational Programs Calendar
March 59, 2012
CPWA Class*
April 1620, 2012
CIMA Class**
April 2325, 2012
IMCA 2012 Annual Conference
National Harbor, MD
May 711, 2012
CPWA Class*
June 1014, 2012
CIMA Class***
June 2529, 2012
CIMA Class**
July 914, 2012
CIMA Class*
* The University of Chicago Booth School of Business
22 Investments&Wealth MONITOR
2012 Investment Management Consultants Association. Reprint with permission only.
I&WM JanFeb2012 Blueline.indd 22
of securities or asset classes. When References
combined with value, substitution Berger, Adam, Ronen Israel, and Tobias
of relative strength for growth styles Moskowitz. 2009. The Case for Momentum
also can build a more-ecient Investing (summer). AQR Capital
portfolio with a higher expected Management. http://www.aqrcapital.com/
return. Relative strength, like all ResearchDetails.htm.
investment methods, has its draw- Jegadeesh, Narasimhan, and Sheridan Titman.
backs, but lack of knowledge has been 2011. Momentum (August). http://ssrn.
the major barrier to its acceptance and com/abstract=1919226.
broader use. Lewis, John. 2011. Bringing Real-World Testing
to Relative Strength (January). http://dors-
Micha e l Mo o dy, C MT, i s s e nio r eywrightmm.com/downloads/hrs_research/
v ic e p r e sid e n t an d s e nio r p o r tf o lio White%20Paper_DWAMM%20RS%20
m an ag e r a t D o r s e y, Wr ig ht Mo n e y Testing.pdf.
Man ag e m e n t in Pa s a d e n a , C A . He Moskowitz, Tobias. 2010. Momentum
i s a for mer e ditor of the Jour nal Investing: Finally Accessible for Individual
o f Te ch n i c a l A n a l y s i s . He e ar n e d Investors. Investments & Wealth Monitor 25,
a B A in p s y cho l o g y an d Eng li sh no. 4 (July/August): 2225.
f r o m P it z e r C o ll e g e . C o n t a c t him a t
mike m @ d o r s e y w r ig ht .c o m . To take the CE quiz online,
visit www.IMCA.org.
Endnote
1 Many of the landmark papers are archived
at www.dorseywrightmm.com under
Resources.
July 16 17, 2012 February 45, 2013
IMCA 2012 Advanced CIMA
IMCA 2013 New York Consultants
Workshop: The Best of Wharton Conference
Philadelphia, PA New York, NY
September 1721, 2012 April 29May 1, 2013
CPWA Class* IMCA 2013 Annual Conference
October 45, 2012 Seattle, WA
IMCA 2012 Advanced Wealth October 78, 2013
Management Conference IMCA 2013 Advanced Wealth
Los Angeles, CA Management Conference
Chicago, IL
November 59, 2012
CPWA Class* May 57, 2014
IMCA 2014 Annual Conference
December 34, 2012
IMCA 2012 Winter Specialty Boston, MA
Conference
Scottsdale, AZ
** The Wharton School, Philadelphia *** The Wharton School, San Francisco
1/31/12 1:53 PM