Investment Strategy: Index Rotation

Editor's note: This was originally published in on RealMoney. It is being republished as a bonus for TheStreet.com readers.

The goal of this series is to provide ideas on how you should structure your investments and offer a basis on which you can read and understand my daily commentary and weekly columns. In part one of this series, I gave an overview of my investment strategy, mostly from an asset allocation perspective.

Index Rotation

The largest portion of my investment strategy for stocks is two index rotation strategies executed through exchange-traded funds. The models provide monthly signals but the average holding period ranges from four to seven months. The goal is to identify themes that will outperform the market over the holding period by producing a return in excess of the S&P 500.

I developed the initial form of this strategy toward the end of my 15-year tenure at my last job, where I managed money for high net-worth individuals and ran the equity research department. Investment performance had gone through a tough period leading up to and after the bursting of the dot-com bubble in 2000.

I was growing frustrated with our large-cap growth at the right price strategy. I felt then and still believe that the advances in information and communication technology had eroded the edge of professional investors, even those who had the best insights and performed the most thorough and insightful analysis. The collapse in trading commissions further evened the playing field.

About the time my frustrations were peaking, I met a new prospect with millions to invest. The prospect had a complex set of accounts that needed better organization and oversight. The caveat was that the clients did not believe in active management using individual stocks. They were pretty well read and knew that most money managers did not outperform their benchmarks.

This presented a bit of conundrum for me. There was no way I was going to turn away a multimillion dollar prospect, but I knew I had to be honest and tell them that index investing was not what my firm did. I asked if the index strategy could be slightly modified to give my firm the authority to rotate among a group of indices. There would be a buy and hold aspect but within ranges I asked for the authority to move among indices based on market cap, economic sectors and international investments.

Don't miss this index-related story: 'Cubes' Drops Into 'Also Ran' Territory

The clients were intrigued but wanted to know what I was going to base the rotation decisions on. Fortunately, in my role as research director I had just established a new relationship with Ned Davis Research (NDR), a well-known investment strategy firm that assists money managers with market timing and investment themes and trends. It is not focused on individual stock selection.

NDR is a quantitative-based shop. The firm tests many measures including economic, bond market and stock market statistics, looking for correlations between up and down market direction and identifying themes that may outperform the market. For example, there is a correlation between dollar weakness and outperformance of large-cap stock indices vs. small cap stock indices.

What I really like about NDR's approach is that there is no belief in any single perfect investment strategy. Instead, the firm looks at many different indicators with a weight-of--the-evidence approach. If a group of indicators that historically has correlated with the Nasdaq outperforming the S&P 500 line up overwhelming in favor of the Nasdaq, it is probably a good bet that it could happen again. The call won't work every time, but the odds are in your favor.

This simple approach closely matches my own view of the world, so when I began to further refine the strategy I was going to use for my new client, I leaned on NDR for help.

After surveying many different models they had developed I decided to focus on two themes: market cap and style. Market cap involves rotation among the large-, mid- and small-cap indices. Style rotates between growth and value indices. I chose these strategies because they had the strongest evidence of being able to add value by producing excess return, and because there were liquid, actively traded ETFs with which to execute the strategy cheaply.

I asked NDR to further test and adapt two models it had developed, one focused on each of my themes. Each model was multifactor, combining at least 10 indicators that individually had a good track record of predicting relative performance. The factors considered a cross section of approaches by looking at economic, bond market and stock market indicators.

I began to use these models back in 2000 and did so with increasing frequency for more clients through 2004, when I decided to start my own firm with my new strategy combining thematic index rotation with narrowly focused individual stock selection in media and telecom.

Part three of this series will appear Wednesday and explain the market cap and style models in detail. In part four, set to publish Friday, I'll explain my approach to investing in media and telecom.


Know What You Own: The most active stocks on Friday included the S&P 500 Depository Receipts ( SPY), the PowerShares QQQ ( QQQQ), the iShares MSCI Emreging Markets Index ( EEM), the Financial Select Sector SPDRs ( XLF), Citigroup ( C), Palm ( PALM) and the Ultra S&P 500 ProShares ( SSO). For more on the value of knowing what you own, visit TheStreet.com's Investing A-to-Z section.

This was originally published on RealMoney on Jan. 9, 2009. For more information about subscribing to RealMoney, please click here.

Steven Birenberg is president and chief investment officer of Northlake Capital Management, LLC. Northlake specializes in managing equity portfolios using a combination of exchange-traded funds and special situation stocks. Birenberg appreciates your feedback; click here to send him an email.

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