October 18, 2013

Momentum Hierarchy

The chart below shows how dual momentum, absolute momentum, and relative momentum stack up against one another with our Dual Momentum Sector Rotation model. (No allowance has been made for transaction or other costs.) The light brown line at the bottom of the chart is the S&P500. The dark brown line just above it is an equally weighted average of all the sectors we use. Its shape is similar to the S&P 500, which means that volatility and drawdown are similar to the market's volatility and drawdown. Equal weighting shows modestly higher returns, due to mean reversion profits from monthly re-balancing and equal, rather than capitalization, weighting across sectors.

performance comparison
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.

The purple line shows relative strength momentum. It has higher profits than equal weighting, but retains the performance characteristics of the S&P500. Relative strength momentum typically boosts returns, but does little to reduce volatility or drawdown. It is the best known and most commonly used form of momentum investing.

When we get to the green line representing absolute momentum, things change. Returns are better than with relative momentum. More importantly, the dips representing larger drawdowns flatten out or disappear. Absolute momentum was out of stocks during all of the 2001-02 and most of the 2008-09 bear markets.

In the hierarchy of investment returns, equal weighting with re-balancing beats the S&P500. Relative strength momentum beats equal weighting. Absolute momentum not only beats relative strength momentum, but it is more stable and consistent. If you have to choose just one approach, then absolute momentum looks best.

However, we are not limited to just one approach. The blue line shows what happens when you combine relative and absolute momentum. Returns improve further while retaining absolute momentum's more attractive risk profile. Dual momentum is where you really want to be.