August 28, 2013

Momentum Combinations

One can use dual momentum in many ways (for a description of what comprises dual momentum, please see our earlier post "Whatchamacallit.") In the Performance section of our website, we show three different applications of dual momentum. The first is our Global Balanced Momentum model (GBM), which applies absolute and relative momentum to a simple global stock/bond portfolio.

Next is our Risk Parity Momentum Composite (RPMC) that uses dual momentum in conjunction with a broader class of assets - US and foreign stocks, REITs, Treasury and credit bonds, and gold. This portfolio corresponds roughly with the risk- parity style portfolio in our latest research paper:  "Absolute Momentum: A Simple Rule-Based Strategy and Universal Trend Following Overlay." RPMC uses the return enhancing and risk reducing characteristics of dual momentum to create a risk parity type portfolio without resorting to leverage or a heavy concentration in bonds.  

Finally, in our Dual Momentum Sector Rotation (DMSR) portfolio, we apply dual momentum to U.S. equities sectors. Sector rotation is one of the better-known and more common ways of using momentum. We introduce dual momentum in place of relative strength momentum, which gives us the added benefit of an absolute momentum market-timing overlay. 

Even though all of our strategies use dual momentum, the monthly correlations between these strategies from 1993 (when sector rotation began) until now is not as high as one might expect:

 Correlations
GBM
DMSR
 GBM
 -
0.65
 RPMC
0.58
0.51

This means there should be some value in combining them. Below are performance results from combining the GBM and RPMC strategies. In accordance with modern portfolio theory, the expected return of the combined portfolio lies somewhere between the returns of the GBM and RPMC portfolios, while the expected volatility and maximum drawdown of the combined portfolio is lower than for both portfolios individually. Combining GBM with RPMC gives us a more conservative overall portfolio:

Jan 1974-Jul 2013[1]
GBM
RPMC
COMBINED
60/40
Global 60/40
Annual Return
13.41
13.93
13.67
10.49
9.33
Standard Deviation
7.73
7.17
6.68
10.33
9.60
Sharpe Ratio
0.96
1.09
1.14
0.46
0.38
Max Drawdown
-12.57
-8.60
-7.15
-32.66
-33.80


We can also take our DMSR sector rotation portfolio and add some parts of the GBM and RPMC portfolios that are missing from DMSR. The rationale here is twofold. First, bonds have been in a 30-year bull market. With interest rates so low now, bonds are not likely to offer the same returns as they did in the past. This means a more equities oriented portfolio like DMSR might now offer advantages over a balanced stock/bond portfolio like GBM or RPMC. 

There is a second reason one might prefer a more aggressive equities oriented portfolio. Even though bonds historically have a lower risk premium and a lower return than equities, investors have historically used bonds to reduce the downside exposure of their stock/bond portfolios. However, the trend following component of dual momentum may also reduce downside exposure and do so without the expected reduction in return from a portfolio that holds a large proportion of bonds. With DMSR, bonds are used only when necessary, i.e., when equities are relatively weak.

There are those who think the stock market is expensive now based on historic P/E ratio analysis. However, that does not mean the stock market cannot go a higher and become even more expensive, as it did in the late 1990s. Markets often go to extremes. The trend following component of dual momentum can help investors stay in stocks longer. Investors will shift from stocks to bonds within a dual momentum framework when bonds are stronger than stocks and it makes the most sense to do so.
  
performance comparisons
We see that we can use dual momentum in a number of different ways. Dual momentum has but one goal - to keep investors in tune with the forces of the markets. Creative combinations of dual momentum can meet the needs of conservative investors, aggressive investors, and those in between.
performance comparison


[1] There are no deductions for transaction or other costs. Maximum drawdown is on a month-end basis. Monthly-rebalanced 60/40 U.S. equities/bond portfolio and 60/40 global equities/bonds serve as benchmarks.
Please see our website Performance and Disclaimer pages for additional disclosures.
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.