These funds are designed around the momentum anomaly discussed extensively on this blog. Fama-French data shows a frictionless annual return greater than 20% for small-cap high-momentum US stocks.
However, there is a another anomaly named “long-term reversal” where poor performers over the past few years (excluding current year) outperform:
Next month performance is in inverse order of past 5 year return, excluding current year (i.e. price 13 months ago minus price 60 months ago).
Chen and Kadan showed that double-sorting on both anomalies leads to significantly increased returns:
(MQ = momentum quintile, RQ = LT reversal quintile, data covers 1926 to 2006)
Update: note that Chen et. al. use a different measure than Fama-French: price 13 months ago minus price 24 months ago.
Simply by excluding the upper half of long term outperformers, monthly returns are increased significantly. Monthly excess returns would rise to 1.30% from 1.15% (i.e. increase by 2 percentage points annually). This filter would be worthy of consideration in the Dorsey-Wright funds.
Essentially, the screen would find stocks with a price history similar to the illustration below, where time zero corresponds to the buy point. A fund manager could then filter that list by other criteria such as earnings or global macro drivers to satisfy the mandate of the fund.