March 27, 2015

Sustainable Momentum Investing: Doing Well By Doing Good

Socially Responsible Investing (SRI), also known as sustainable or responsible investing, is the application of ethical as well as financial considerations in making investment decisions. SRI therefore recognizes and incorporates societal needs and benefits.

History of SRI

SRI may first date back to the Quakers who, in their 1758 yearly meeting, prohibited members from participating in the slave trade. The Quaker Friends Fiduciary has existed since 1892 and continues to manage its assets following SRI guidelines.
Another early adopter of SRI was John Wesley (1703-1791), one of the founders of the Methodist Church. Wesley’s sermon on “The Use of Money” outlined the basic tenets of social investing – do not harm others through your business practices and avoid industries which can harm the health of others. In the 1920s, the Methodist Church of Great Britain invested in the UK stock market while avoiding companies involved with alcohol and gambling.

The first public offering of a socially-screened investment fund was in 1928 when an ecclesiastical group in Boston established the Pioneer Fund. In 1971, a Methodist group organized the PAX World Fund, which appealed to investors who wanted to be sure their profits were not from weapons production.  Two years later, SRI went mainstream when Dreyfus, a major mutual fund marketer, launched the Third Century Fund, which grouped together companies noted for their sensitivity to the environment and to their local communities.

Social Change through SRI

In the 1980s, SRI became more widespread with its negative screening of investments in South Africa. SRI practitioners were able to put pervasive pressure on the South African business community. This eventually forced a group of businesses representing 75% of South African employers to draft a charter calling for the end of apartheid.

SRI Performance

Although SRI has helped bring about social change and has been emotionally rewarding to its users, there has been a question about whether or not SRI performance might suffer due to the restricted opportunities available to SRI investors. There have been many studies and meta-studies of SRI versus conventional investment past performance. One objective survey and assessment of the subject is by the Royal Bank of Canada in their report "Does Socially Responsible Investing Hurt Investment Returns?" The conclusion they reach is that investors in the past have been no worse off with SRI than with more conventional investing.

Evolution of SRI

SRI evolved from exclusionary screening out of investments to include a more proactive approach toward Corporate Social Responsibility (CSR). This SRI/CSR approach became a blend of negative and positive screening methods in order to maximize financial return within a socially aligned investment strategy. Negative screening excludes companies that are incompatible with investors’ ethical values, while positive screening seeks to invest in companies that act in a manner that is consistent with investors’ values. Examples of negative screening factors are involvements with gambling, adult entertainment, alcohol, tobacco, weapons, under age workers, animal testing, and damage to the environment. Examples of positive screening criteria are pollution control, community involvement, energy conservation, consumer protection, human rights, diversity, product safety, employee working conditions, and renewable energy sources. CSR oriented programs can also vote their proxies to advance ethical business practices, such as diversity, fair pay, and environmental protection.

The inclusion of CSR further evolved and expanded to include a broader set of Environmental, Social, and Governance (ESG) factors. Interestingly, these were soon found to be correlated with superior risk-adjusted investment returns. ESG was seen to have practical benefits for the companies that employ these criteria, as well as for investors in those companies.

There are number of reasons for improvements in performance because of ESG. Corporate responsibility can create good relationships with governments and communities, as well as reduce the risks of onerous regulations and conflicts with advocacy groups. It can also influence how consumers perceive a brand and therefore serve a similar role to advertising. This can lead to higher sales and more loyal customers. In addition, corporate responsibility can have a positive influence on companies’ ability to attract and retain talented employees and maintain productive workforces.

Performance of  SRI/CSR/ESG

According to DB Climate Change Advisors in their 2012 meta-analysis of more than 100 academic studies, “Sustainable Investing: Establishing  Long-Term Values and Performance,” 100% of studies showed that companies with high ESG ratings exhibited financial outperformance and had a lower cost of capital than more conventional companies, while 89% of highly-rated ESG companies exhibited market-based outperformance and superior risk-adjusted stock returns.

One typical study by Eccles et al. (2011) compared the performance of 180 large U.S. firms by matching 90 high sustainability firms with 90 low sustainability firms. Beginning in 1993, $1 invested in the high sustainability portfolio would have grown to $22.60 by 2010, while the low sustainability portfolio grew to only $15.40.

From an investment point of view, socially responsible mutual funds have done even better in Europe than in the U.S. Europe has always relied more on positive screening criteria, rather than the negative screening that has dominated U.S. funds until recently.

Rapidly Growing Investor Interest

Companies doing well now by doing good have not gone unnoticed by investors. The outperformance of high sustainability firms has been attracting considerable investor interest. According to a 2015 survey by the Morgan Stanley Institute for Sustainable Investing, over 70% of active individual investors describe themselves as interested in sustainable investing, and nearly 2 in 3 believe sustainable investing will become more prevalent over the next 5 years.

Looking at actual recent growth, the global sustainable market has risen from $13.1 trillion at the start of 2012 to $21.4 trillion at the start of 2014, and from 21.5% to 30.2% of all professionally managed assets. Europe has the highest percentage of sustainable assets at 63.7%. But the U.S. has been the fastest growing region over this period and now has 30.8% of all global sustainable assets. The amount of funds invested in the U.S.using social criteria grew from $40 billion in 1984 to $625 billion in 1991 and $1.5 trillion in 1999.

According to the most recent biennial "Report on U.S. Sustainable, Responsible, and Impact Investing Trends" by the Forum for Sustainable and Responsible Investing (US SIF Foundation), the number of ESG mutual funds in the U.S. were 456 at the start of 2014, up from 333 two years earlier. Assets in U.S. sustainable funds were $6.57 trillion at the start of 2014, up from $3.74 trillion at the start of 2012. This is a growth of 76% in just two years. Assets held in some form of sustainable investment now account for more than $1 out of every $6 under professional management, up from $1 out of every $9 in 2012.

Dual Momentum with SRI/CSR/ESG

In my book and on my website I show how dual momentum can enhance the performance of many different kinds of investment portfolios, such as global equities, balanced stocks and bonds, equity sectors, and fixed income. I thought I would now turn my attention now toward using dual momentum to improve upon the risk-adjusted returns from sustainable investing.

I usually prefer to use low cost, index ETFs as investment vehicles. However, that may not be the best approach with sustainable funds. There are two reasons for this. First, the difference between index ETF and actively managed funds’ annual expense ratios is not nearly as large for sustainable funds. For example, the  annual expense ratios for the Vanguard and iShares S&P 500 ETFs are .05 and .07, respectively. The annual expense ratios of the two KLD 400 Social Index ETFs, on the other hand, are much higher at .50. When you compare the sustainability ETFs with expense ratios of .50 to the S&P 500 ETFs with expense ratios of .05 or .07, the sustainability ETFs are at a decided disadvantage to their conventional counterparts.

The second reason that sustainability index funds can be problematic is their short performance records. The earliest U.S. based SRI index is the Domini 400 Social Index, which is now known as the MSCI KLD 400 Social Index. It did not begin until May 1990, and data for it is not readily available. The oldest SRI index  fund (Vanguard FTSE Social Index) was established only 15 years ago in May 2000.[1] Readers of my book should know that 15 years is too short a period to evaluate with confidence any strategy based on monthly returns.

For these reasons, as well as the reason that active management might add some value in an area like sustainability, where more informed choices might be better than the mechanical rules of an index,  we will look to apply dual momentum to the oldest, actively managed, sustainable equities-based mutual funds.

Funds Used

The three sustainability equity funds that have track records longer than 25 years are Dreyfus Third Century (DRTHX) that began in April 1972, Parnassus (PARNX) that started in May 1985, and Amana Income (AMANX), that began in July 1986.[2] 

Looking at these funds now, the only explicit exclusionary screen of Dreyfus Third Century is for tobacco products. However, Third Century has a strong ESG orientation by reason of their mandate to invest in companies that contribute to the enhancement of the quality of life in America, with special emphasis on the environment, product safety, employee safety, and equal opportunity employment. Third Century’s annual expense ratio is 1.01, and the fund is closed now to new investors. However, the institutional class of shares (DRTCX), with an expense ratio of .91, can still be purchased ($1000 minimum) through some financial professionals and brokerage firms. 

Parnassus Fund has an annual expense ratio of .86.This fund screens out companies involved with alcohol, tobacco, gambling, nuclear power, and weapons. Parnassus also engages in shareholder activism and community investment. The fund has a strong ESG orientation with its mandate to invest in companies having sustainable competitive advantages and ethical business practices. Parnassus also prefers to buy out-of-favor stocks.

Besides incorporating ESG factors and exclusions for alcohol, tobacco, gambling, and adult entertainment, Amana Income (AMANX) avoids companies with high debt-to-equity ratios and large receivables compared to total assets. Their emphasis on companies with stable earnings, high quality operations, and strong balance sheets free of excessive debt gives Amana a tilt toward quality, which is now recognized in academic circles as a worthwhile risk premium factor.[3]

In addition, Amana prefers to hold shares in companies where management has a sizable stake, and the fund will sell shares in companies where insiders are selling.  There is a body of academic literature confirming that insiders are better informed and earn abnormal profits from their trades.[4]  Amana Income has an expense ratio of 1.14, plus .25 in 12b-1 fees. However, institutional shares (AMINX) are available with an expense ratio of .90 and no 12b-1 fees. These require a minimum investment of $100,000.

Here are performance figures through February 2015 for our three sustainability funds starting from July 1986, when performance data begins for Amana Income. We also include the Vanguard 500 Index (VFINX) fund as a benchmark. Vanguard 500 has an expense ratio of .17 [5]

Ann Rtn 9.80 12.63 9.71 11.35
Std Dev 15.79 21.71 12.02 15.32
Sharpe 0.37 0.39 0.48 0.47
Max DD -59.98 -47.98 -34.70 -50.97

We see that Parnassus has a higher return than the S&P 500 with around the same maximum drawdown, while Amana Income has about the same Sharpe ratio as the market with a lower maximum drawdown. The lack of performance homogeneity among these funds is good for relative strength momentum. More separation in performance creates more opportunities for profits.So let us see now what happens when we apply dual momentum to these funds.

First though, I should mention a potential problem of using higher cost actively managed funds with dual momentum. The performance of actively managed funds may revert toward the mean of all  funds and be overtaken by the performance of lower-cost index funds. However, this may not be such a problem for us here for two reasons.

First, we are not selecting actively managed funds based on superior past performance that might subsequently mean revert. We are simply using the three sustainability funds that have the longest track records. Second, we can easily include a low-cost stock index fund in our dual momentum portfolio. Dual momentum is adaptable.If there is a falloff in performance of our actively managed funds, dual momentum should automatically move us to the lower-cost index fund. This is how we can confidently use actively managed funds within a dual momentum portfolio framework.

Performance Results

Here is the same performance we saw above but with the addition of a dual momentum portfolio made up of all three sustainability funds, the Vanguard 500 index fund for the reason given above, and the Vanguard Total Bond (VBMFX) fund as a refuge when absolute momentum takes us out of equities. The operating logic behind this model that we call ESG Momentum (ESGM) is the same as for our Global Equities Momentum (GEM) model. It is fully disclosed in my book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk

Ann Rtn 9.80 12.63 9.71 11.35 6.48 16.91
Std Dev 15.79 21.71 12.02 15.32 3.90 13.96
Sharpe 0.37 0.39 0.48 0.47 0.69 0.87
Max DD -59.98 -47.98 -34.7 -50.97 -5.86 -22.73
% Used 12 35 13 17 23 100

Results are hypothetical, are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Please see our Disclaimer page for more information.

We see that the Sharpe ratio of our ESGM portfolio is more than twice as high as the average Sharpe ratio of the four equity funds, and the ESGM maximum drawdown is less than half as large. By being in bonds 23% of the time, ESGM was able to bypass the full severity of the bear market drawdowns.

ESGM was in the three sustainability funds 78% of the time that it was in equities, so our mission was accomplished of being mostly in investments that contribute to advancements in social, environmental, and governance practices, while simultaneously giving us exceptional risk-adjusted returns through the use of dual momentum.  A link to the ESGM model's monthly and annual results is now on the Performance page of our website. It will be updated monthly along with the rest of our dual momentum models.

[1] The two social responsibility ETFs, KLD and DSI, began in 2005 and 2006 respectively.
[2] PAX World Balanced began in August 1971 and CSIF Balanced Portfolio began in October 1982, but both funds have large allocations to bonds. 
[3] See Asness et al. (2013), "Quality Minus Junk.".
[4] For example, see Jeng et al. (2003) "Estimating the Returns to Insider Trading: A Performance Evaluation Perspective" or  Seyhun (1998), Investment Intelligence from Insider Trading
[5] We could have used Vanguard's Admiral shares with an expense ratio of .05 or a low-cost S&P 500  ETF, but we wanted to be consistent with the retail shares we used for our socially responsible funds.

February 24, 2015

Do the Right Thing: Consider Persistence and Reversion

I used to always cut fruits and veggies in the wrong directions. I finally got around this problem by  turning them in the opposite direction to the way I initially wanted to cut them. Similarly, many investors and investment managers are making investment decisions the wrong way and need to reverse how they are going about this.

This problem began with the random walk hypothesis (RWH). That idea, popular in the 1960s and 1970s, said that stocks fluctuate randomly (in statistical terms, are independent and identically distributed). RWH is synonymous with the concept of efficient markets. As such, it eliminated serious interest in tactical asset allocation, trend following, or momentum investing among both academics and most institutional investors.

Some practitioners, however, were creating a substantial body of anecdotal evidence that stock fluctuations were not random, but instead showed short and long-term mean reversion, as well as intermediate- term serial correlation. 

Stock exchange specialists and brokerage firm trading desks made large profits going against short-term customer order flow, which gave them high short-term mean reversion profits. The success of momentum traders like Jack Dreyfus and Richard Driehaus showed that stocks could also exhibit price continuation (momentum). Successful long-term value investors, buying depressed stocks that would eventually recover and outperform the market, indicated that one can also earn long-term mean reversion profits from stocks.

In the mid to late 1980, academics began to catch up with practitioners in discovering the flows of RWH. Ironically, Fama and French (1988), two of the pioneers of efficient market theory, were among the first to show that stocks mean revert based on a 3 to 5-year time horizon. Around the same time, Lo and MacKinlay (1988) and Poterba and Summers (1987) came up with compelling evidence to reject RWH. In the early 1990s, Jegadeesh and Titman (1993) in their seminal papers demonstrated convincingly that price continuation momentum exists on a 3 to 12-month basis. Furthermore, they and others showed that stocks are mean-reverting when looking at one-month returns. They therefore skipped those returns when looking at intermediate-term stock momentum.

Showing just how far academics have come in accepting  12-month momentum (indicating positive serial correlation) , one-month mean reversion, and 3 to 5-year mean reversion, all three of these factors are now in the online Ken French data library for researchers to use in their studies.

So how does all this relate to how investors and investment managers are making poor investment decisions? First, there is still a cultural affinity to RWH despite all the evidence to the contrary. This leads many investors to ignore the profit opportunities inherent in momentum investing.

Next, investors and investment professionals often focus on the wrong time frames in judging investments. Goyal and Wahal (2008) report  that plan sponsors and institutional asset managers choose investment managers based greatly on performance over the past 3 years. Yet we know now that 3-year performance is mean reverting, and strong performance over that time frame is not indicative of similarly strong future results.

As another example, the Morningstar rating methodology weights 3-year performance more heavily than 5 or 10-year performance. If longer term performance is unavailable, ratings are based entirely on 3 year performance. The Vanguard Research report "Mutual Fund Ratings and Future Performance" (2010) found that from February 1992 through August 2009, there was no systematic outperformance by funds rated 4 or 5 stars by Morningstar or underperformance by funds rated 1 or 2 stars.The median 5-star fund's excess return was not consistently higher than the median 1-star fund's excess return.  

Vanguard also reported that investment committees typically use a 3-year window to evaluate the performance of their portfolio managers.  Yet we know that investors and asset managers should focus more on performance outside the 3 to 5-year performance window due to mean reversion using that time frame.

The other problem in performance evaluation is often found among individual investors who overreact to short-term results. When I managed investment partnerships in the 1970s and 1980s, my investors would invariably want to add funds after a single month of strong performance, and, conversely, they would almost never add to their accounts following a significant down month. Short-term mean reversion implies that they should have been doing just the opposite. Dalbar's annual "Quantitative Analysis of Investor Behavior"  supports the idea that investors overreact to short-term performance by buying highs and selling lows instead of keeping the big picture in mind, which seriously harms their long term returns. [1]

Doing what may be the wrong thing has even been adopted as an investment strategy by the Global X JP Morgan Sector Rotation ETF (SCTO). This fund buys the strongest U.S. stock market sectors based on only the prior month’s performance. 

So there you have it. Investment committees, institutional asset managers, Morningstar, and others emphasize 3-year past performance as an indicator of future success, when the just opposite is likely to be true. Adding to this confusion, individual investors and others chase after strong 1-month performance by buying these short-term rallies when they would be better off buying dips.  

Investors and investment managers take heed. Do the right thing. Read the literature. And, if you need to, don’t forget to turn your fruits and veggies in the right direction.

[1] One of the advantages of using a trend following filter like absolute momentum (which is half of dual momentum) to identify regime change and reduce drawdown is that can also reduce investors' loss aversion, ambiguity aversion, and the flight-to-safety heuristic. It may therefore give investors more confidence to stay with the trend and even buy dips.

January 21, 2015

And the Winner Is...

Until recently, the longest back test using stock market data was Geczy and Samonov’s 2012 study of relative strength momentum called “212Years of Price Momentum: The World’s Longest Backtest: 1801-2012”. The length of that study has now been exceeded by an 800 year backtest of trend following in Greyserman and Kaminski’s new book, Trend Following with Managed Futures: The Search for Crisis Alpha. The authors looked at 84 equities, fixed income, commodities, and currencies markets as they became available from the years 1200 through 2013. They established long or short equal risk sized positions based on whether prices were above or below their rolling 12-month past returns.

The average annual return of this strategy was 13% with an annual volatility of 11% and a Sharpe ratio of 1.16. In contrast to this, buy-and-hold  had a return of 4.8%, volatility of 10.3%, and a Sharpe ratio of 0.47.  Maximum drawdown for trend following was also significantly lower than for buy-and-hold. Equities alone with trend following showed a substantially higher Sharpe ratio and nearly a 3% greater annual return than with buy-and-hold from 1695 through 2013.

However, let’s not just look at trend following on its own.  Let’s also compare it to other possible risk reducing or return enhancing approaches and see what then looks best. We will base our comparisons on the performance of U.S. equities because that is where long-run risk premium and total return have been the highest. We also have U.S. stock market data available from the Kenneth French data library all the way back to July 1926.

We will first compare trend following in the form of absolute momentum to seasonality and then to the style and factor-based approaches of value, growth, large cap, and small cap.[1] We will also see if it makes sense to combine these with trend following.

For seasonality, we look at the Halloween effect, sometimes called “Sell in May and go away…” This has been known to practitioners for many years. There have also been a handful of academic papers documenting the positive results of holding U.S. stocks only from November through April. The following table shows the results of this strategy compared with absolute momentum applied to the broad U.S. stock market from May 1927 through December 2014. With 10-month absolute momentum, we are long stocks when the excess return (total return less the Treasury bill rate) over the past 10 months has been positive.[2] Otherwise, we hold Treasury bills. We also hold Treasury bills when we are out of U.S. stocks according to the Halloween effect (in stocks Nov-Apr, out of stocks May-Oct). 


US Mkt
Annual Return
Annual Std Dev
Annual Sharpe
Maximum DD

Results are hypothetical, are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

We see that the 6-month seasonal filter of U.S. stock market returns substantially reduces volatility and maximum drawdown but at the cost of reducing annual returns by over 200 basis points. Trend following absolute momentum, on the other hand, gives a greater reduction in maximum drawdown than seasonality with almost no reduction in return. There is little reason to consider seasonal filtering when absolute momentum gives a greater reduction in risk without diminished returns.   

The table below shows the U.S. market separated into the top and bottom 30% based on book-to-market (value/growth) and market capitalization (small/large). We see that value and small cap stocks have the highest returns but also the highest volatility and largest maximum drawdowns. 


US Mkt
Annual Return
Annual Std Dev
Annual Sharpe
Maximum DD

Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

Most academic studies ignore tail risk/maximum drawdown, but these can be very important to investors. Not many of us would be comfortable with 90% drawdowns.[3] In addition, on a risk-adjusted basis (Sharpe ratio), neither small cap nor value stocks appear much better than growth or large cap stocks. This is consistent with recent academic research showing a lack of small size premium and a value premium that is associated mostly with hard-to-trade micro cap stocks.[4] Let’s now see what happens now when we apply absolute momentum to these market style segments:

                                                       Style w/Absolute Momentum

Annual Return
Annual Std Dev
Annual Sharpe
Maximum DD

Results are hypothetical, are NOT an indicator of future results, and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Please see our Disclaimer page for more information.

In every case, adding absolute momentum reduces volatility, increases the Sharpe ratio, and substantially lowers maximum drawdown. The biggest impact of absolute momentum, however, is on large cap stocks, followed by the overall market index. The use of a trend following absolute momentum overlay further reduces the relative appeal of value or small cap stocks.   

One may wonder why large cap stocks respond better to trend following. The answer may lie in a study by Lo and MacKinlay (1990) showing that portfolio returns are strongly positively autocorrelated (trend following), and that the returns of large cap stocks usually lead the returns of small cap stocks. Since trend following lags behind turns in the market, investment results should be better if you can minimize that lag by being in the segment of the market that is most responsive to changes in trend. That segment is large cap stocks, notably the S&P 500 index, which leads the rest of the market.[5]

In my book, Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk, I give readers an easy-to-use, powerful strategy incorporating relative strength momentum to select between U.S. and non-U.S. stocks, and absolute momentum to determine market trend and choose between stocks or bonds. I call this model Global Equities Momentum (GEM). And what index is the cornerstone of GEM? It’s.the S&P 500, the one most responsive to trend following absolute momentum and that gives the best long-run risk-adjusted results. 

Einstein said you should keep things as simple as possible, but no simpler. One can always create more complicated models or include more investable assets. But as we see here, trend following momentum is best when it is simply applied to large cap stocks.

[1] There is a study showing the effectiveness of absolute momentum back to 1903 by Hurst et al. (2012).
[2] We use 10-month absolute momentum instead of the more popular 10-month moving average because absolute momentum gives better results and 35% fewer trades, which means fewer false signals and whipsaw trades. See our last blog post, "Absolute Momentum Revisited". 
[3] The next largest maximum drawdown was 64.8 for value and 69.1 for small cap on a month-end basis, which were again the largest ones. Intramonth maximum drawdowns would have been even higher.
[4] See Israel and Moskowitz (2012).
[5] U.S. stock market returns also lead non-U.S. stock market returns. See Rapach, Strauss, and Zhou (2012).