Harnessing the Stock Market's Natural Rotation

Harnessing the Stock Market’s Natural Rotation: An Asset Allocation Strategy

“Historically, overweighting the in-favor style and underweighting the out-of-favor style would have resulted in higher returns than investing in the broad market.”

Rick Golod, Director of Global Investment Strategies, Invesco

Asset allocation strategies have continued to evolve since Harry Markowitz pioneered the concept of Modern Portfolio Theory (MPT) in 1952.

As a consequence, the standard 60% stock/40% bond portfolio of yesteryear now includes other asset classes such as international equities and debt, real estate, commodities, currencies, private equity and the more contemporary “liquid” alternatives such as mutual, exchange-traded and closed-end funds.

In theory, diversifying a portfolio across asset classes and investment styles should help reduce the overall volatility and smooth returns long term. However, the recent GFC exposed a considerable flaw in the application of MPT.

This problem is especially true in the US equity market, where investor portfolios tend to be diversified with nine standard style categories, covering large-, mid- and small-caps, and value-, growth-, and blend-oriented stocks. However, these styles typically have high correlations with the S&P 500 Index.

It’s also worth noting that the equity market has historically tended to follow a natural rotation pattern. Although past performance is no guarantee of future results, this strategy has worked 77% of the time in the past 35 years. 

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