Can Technical Analysis Boost Portfolio Returns?

A recent white paper authored by David Smith, Christophe Faugère, and Ying Wang, entitled, Head and Shoulders above the Rest? The Performance of Institutional Portfolio Managers who Use Technical Analysis, may help to change the way technical analysis is thought of in the world of asset management. In a broad-based study examining two decades worth of returns, the authors found that fund managers who employed technical analysis, which relies on the study of price and volume data to predict the future direction of stocks and other financial instruments, delivered higher returns than those who did not.

Technical analysis has long been treated with a certain degree of scorn — or at least skepticism — by the stock market cognoscenti. Perhaps it is the suggestion implicit in technical analysis that something other than rigorous fundamental analysis is behind all the buying and selling. “Chartists,” as they are known, see asset prices as a function of supply and demand, and while technical analysts generally agree with the efficient market hypothesis (EMH) insofar as markets quickly reflect all available information, it is at this point that the disciplines part ways. Technicians believe that price patterns tend to repeat over time and, as a result, are somewhat predictable. The repetitive behavior of markets is a result of the irrationality of investors. This irrationality mainfests itself in behavioral biases that are, in the view of technicians, exploitable.

Past studies of the efficacy of technical analysis came to a range of conclusions and no firm consensus. Eugene Fama and Marshall Blume, in Filter Rules and Stock Market Trading (1966), found that technical analysis did not beat simple buy-and-hold strategies after transaction costs. More recent studies, including a paper by William Brock, Josef Lakonishok, and Blake LeBaron entitled Simple Technical Trading Rules and the Stochastic Properties of Stock Returns (1991), suggest some benefit from trading on technical indicators, including moving averages and trading range breaks.

Smith, Faugère, and Wang — all professors at the School of Business at the State University of New York at Albany — take a different, more holistic approach than prior studies. Rather than testing individual technical trading rules, they simply relied on portfolio managers’ assertions about whether or not, and to what extent, they employed technical analysis in their investment process. The authors’ sample includes 10,452 actively managed US equity, global equity, US balanced, and global balanced portfolios. They find that technical analysis was utilized to some degree by about one-third of the managers surveyed, with US equity fund managers the most avid users and US balanced fund managers the least frequent users. There were no notable differences in the use of technical analysis by market capitalization of holdings.

Examining performance between 1993 and 2012, the authors considered several different performance metrics and found mean and median alpha values, as well as volatility, to be consistently higher for those funds using technical analysis. They conclude:

“[The] cross-section of portfolios managed using technical analysis shows remarkably elevated skewness and kurtosis values relative to portfolios that do not use technical analysis. In the presence of the former, the latter can be advantageous.”

While the paper suggests that technical analysis may indeed boost portfolio returns, it is not clear whether it also extends careers. Over the course of their study, the authors found that 55% of those disavowing the use of charts were still in business, while only 48% of those managers who rated technical analysis as “very important” had survived. Although the authors convincingly demonstrate that fund managers might enhance their portfolios’ performance through the use of technical analysis, they don’t tell us which trading rules are most effective. And for those who have successfully employed technical analysis, the incentives to divulge their “secret sauce” are few.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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