March 12, 2010

Why SMI's Upgrading strategy works

You never know when inspiration will strike. I was recently skimming this Morningstar article — which explains how several of the top foreign value managers are drawing opposite conclusions regarding Japan as an investment opportunity — when I realized, "This article is explaining why SMI's Upgrading strategy works!"

The article reports on how six specific foreign large-cap value managers disagree over the prospects for a Japanese stock market recovery. This would normally merit a giant "who cares?" reaction, except for the fact that these particular managers are the absolute elite of their peer group. Six Morningstar Manager of the Year awards between them, and great long-term results from all six funds. And they happen to be split right down the middle in their opinions regarding Japan.

So how does this explain why Upgrading works? Because in this disparity of outlooks, and the resulting differences between these funds portfolios, we see how the Upgrading process can move us between winning ideas even within relatively narrow peer groups, while steering us clear of losing ideas.

If half this group is in Japanese stocks and the other isn't, it stands to reason that half of this group will do well and half will do poorly, regardless of which path Japanese stocks take. And Upgrading will pick up on whichever group is correct and steer us towards those funds.

In other words, we don't have to figure out which group is right and which is wrong (which is good, because I don't have the foggiest idea). Instead, we can simply follow our mechanical guidelines and the correct answer will play itself out in our fund rankings. We get the benefit of whichever group has this issue figured out correctly, even though right now we don't have any idea which side has the winning argument.

This example also helps illustrate why conventional funds go through periods where they put up phenomenal returns, only to stumble badly over the next few years. It's easy to get big-picture predictions like this wrong from time to time, and suffer for a year or two (or three) because the fund's portfolio was positioned incorrectly as a result. Upgrading helps us side-step those periods of poor performance, while steering us towards those managers who were the most accurate in positioning their portfolios to take advantage of the issues that matter most to the market right now.

Naturally, Upgrading isn't perfect and carries its own set of challenges. Nonetheless, it is a strategy that has beaten the market in 10 out of the past 11 years. It works not only because it steers us clear of certain challenges inherent to most "normal" funds, Upgrading actually uses those very challenges as the basis for its success.