Stellaluna9 recently asked a very interesting/important question (//itawealth.com/momentum-systems-part-6-rutherford-back-tests-projection-vs-convolution_2/#comment-7938):
“I am new to use of the spreadsheets, but have created duplicate spreadsheets as Lowell has reviewed them. As I go, I hope I am developing a better understanding of what is behind all the calculations (the black box, if you will). For background to my eventual questions, I have a Kepler portfolio with my holdings added in. There are a total of 38 tickers in the spreadsheet and I am invested in 18 of them, including EEM (emerging marking etf). EEM’s ranking is 22. Of the 18 that I am invested in, five are mutual funds and 13 are ETF’s. I am invested in some of the Kepler holdings. The only two Kepler holdings that I am not invested in and that rank above EEM were SPTM and SPEM. The following centers around the EEM 22 ranking.
I have a Morningstar account and have these 18 “stocks” in a portfolio. EEM’s rankings among the 18 follow: 1 week=#1, 1 month=#2, 3 months=#5, and 12 months=#5. The 3-yr standard deviation is 15 and its Morningstar risk is Above Average. Seven of the stocks have Morningstar risk at Above Average and High.
Finally, my question. Given Morningstar’s return rankings over the last year, why do you think the LRPC spreadsheet is ranking EEM so low? The Tranche rankings range from 22 to 39. I was thinking about pairing the number of holdings to 15, but not inclined to sell EEM, at least for now. What do you think is over-riding EEM’s high relative returns among the holdings? My very uneducated guess is that it has something to do with the regressions since I have a hard time believing it’s the 50/30/20 weights. Am I missing something?”
In order to provide a response to these comments/questions I have to go back a number of years to the time when I started to develop the ranking SSs that we feature on this site. At that time there was significant discussion as to how many assets should be evaluated when considering possible candidates for inclusion in a portfolio. It was the ”early days” in the popularity of ETFs and it took a while for most of us to recognize that an ETF (generally) was, by construction, a “diversified” asset. i.e., that, unlike the ”old days” when we might have to purchase, say, 10 individual stocks to reduce/minimize unsystematic risk, that this risk could be covered simply by holding a single ETF.
It was my (personal) opinion that it was beneficial, and most effective (when using a ranking comparison methodology), to keep the ranking list small – otherwise the law of large numbers becomes an issue when ranking. I believe I suggested a list no larger than 20 assets (ETFs). However, many ITA members wanted to compare more assets. As a compromise I made a decision to limit the number of assets that could be compared within a single workbook/spreadsheet to 40 assets. This forced an investor to split larger lists into sub-lists – with considerations of diversification (different asset classes/correlation between assets).
So, that’s the quick “catch-up” background for new ITA members. In response to Stellaluna9’s specific question related to EEM, I haven’t tried to reproduce a 38-asset list similar to that being analyzed by Stellaluna9, but I have added EEM to the (short, diversified) default asset list distributed with the LRPC workbook. Here’s what the rankings/recommendations look like:
Here, we see that EEM is ranked #2 in this list and, with a PC plot as shown below…
… there would be no reason to sell EEM from a portfolio – unless the number of assets to be held were exceeded and a better candidate (with higher ranking) were indicated. EEM might be moving into overbought territory – but there is no obvious sell signal at this point in time – green lights everywhere.
Since I do not know which assets Stellaluna9 has included in his 38-asset list I can only speculate that the list contains a large number of highly correlated assets that are currently dominating the rankings because of the recent strong performance of those assets (probably in the same – US equity? – asset class). Therefore, this does not say, just because EEM is only ranked #22, that it should not be held in the portfolio. All it says is that 21 of the assets in the list have higher relative momentum and might be better candidates. Rather, it begs the question as to whether the list is suitably diversified to achieve an investor’s objectives/goals based on the use of a ranking system.
I would probably try to split the 38-asset list into at least 2 smaller lists – with diversification (uncorrelated assets) included in each list, maybe reviewed at different times – or similarly correlated assets in each list with the top ranked assets from each list being combined in the final portfolio.