“The one size fits all approach of standardized testing is convenient but lazy.” – James Dyson

In my travels around the country presenting to and meeting with hundreds of financial advisors and individual investors, I’ve been fortunate to really get a clearer understanding of how people in the business of portfolio management think. Those who have attended my various Chartered Financial Analyst (CFA) and Market Technicians Association (MTA) Chapter presentations on our award winning papers come out of the sessions with a deeper understanding of how Utilities and Treasuries can help with predicting stock market corrections and volatility. The presentation has evolved over the past six months, now hitting on topics related to behavioral finance, false positives, anomaly persistence, and discipline in sticking to an investment strategy beyond the small sample we all live in.

Occasionally in my one on one meetings with advisors discussing our research I receive a degree of skepticism about the strategies outlined in those papers. Some simply do not believe in backtesting market behavior, whereby historical price movement is analyzed and a strategy is created to better position for that path of equity or bond returns.  Whenever I encounter disbelief in backtested results, I end up asking that person if he or she believes in buy and hold instead of backtested strategies.  The answer is always yes.

The next question I then ask is a simple one – isn’t buy and hold itself a backtest?

Think it through. A backtested strategy is one that looks at historical market behavior and cycles, creates a trading rule, and then repeats that rule in a disciplined quantitative way.  The results either show a persistent anomaly exists which can be exploited (momentum, small-cap effect, mean reversion, etc), or the backtest fails. Buy and hold is nothing more than a backtest as well. It is a trading rule with one decision: buy. In addition, one can argue buy and hold is an anomaly throughout time as well given how persistently doing nothing seems to outperform the vast majority of traders and investors who act on noise and not signal.

Every backtested strategy, and every anomaly of course has its own cycles. No strategy works all the time. Even in the 2014 Dow Award winning paper on Beta Rotation, we show that the backtest of a rotation around Utilities and the stock market underperforms the stock market going back to 1926 around 20% of the time on a rolling 3 year basis. The anomaly documented in that paper which is what we attempt to take advantage of in our alternative and equity mutual funds and separate accounts itself has cycles, just like buy and hold does.

This leads us to today. As mentioned in my last week in review writing I alluded to the idea that rates may finally rise and the yield curve could steepen, simply as a contrarian trade to an unrelenting trend.  That indeed has happened. Our inflation rotation strategy nicely took advantage of the January Treasury strength and held on to it as buy and hold of Treasuries so far in 2015 has largely given back those gains. Our beta rotation strategy was among the few US equity approaches positive in January as everything else fell hard, and continues its lead. Why? Because the cycle of volatility and risk management appears to re-asserting itself. Our entire approach is built on proven leading indicators of exactly those types of environments over time.

There are some very powerful trades that we believe we have the ability to take advantage of this year as the indicators that drive our models begin to reassert themselves in a normalizing environment. If indeed our cycle is about to return, then the buy and hold backtest will itself have its own period of weakness. The timing of this makes some sense given the likelihood of the Fed raising rates this year. Perhaps the complete love of passive indexing which everyone seems to want now, but no one wanted in March 2009, is due to work less well.

Diversification is nothing more than the process of combining low or uncorrelated backtests in a portfolio, attempting over time to smooth out returns and generate wealth. Some backtests in certain periods work better than others. That’s exactly why combining multiple strategies and asset classes in a portfolio over long periods of time tends to be superior to the trade of the moment. To that end, we are at the moment very excited for how intermarket relationships are now finally behaving.