Dual Momentum Investing With Mutual Funds

Gary Antonacci's  ”Risk Premia Harvesting Through Dual Momentum” paper available on Optimal Momentum first piqued my interest in using absolute and relative momentum to invest in small groups of asset classes. Antonacci states that “relative momentum looks at price strength with respect to other assets, while absolute momentum looks for an asset's own positive excess return over a given look back period.”

Using ETFReplay.com I created three portfolios to test the efficacy of a strategy similar to the one outlined at Optimal Momentum.  The portfolios were constructed using mutual funds (a new feature of ETFReplay) as opposed to ETFs, due to the longer trading histories of many mutual funds. My objective was to create three portfolios representing three unique asset classes.

The first portfolio is an equity portfolio consisting of the following:

Vanguard Emerging Markets – VEIEX

Vanguard Short-Term Treasury – VFISX

Vanguard Total Stock Market – VTSMX

The second portfolio is a bond portfolio consisting of the following:

T. Rowe Price Emerging Markets Bond – PREMX

Vanguard Long-Term Investment Grade – VWESX

Vanguard Short-Term Treasury - VFISX

The third portfolio is a real asset portfolio consisting of the following:

Vanguard Short-Term Treasury - VFISX

Vanguard Precious Metals & Mining – VGPMX

Vanguard REIT – VGSIX

The strategy for the backtests involves purchasing one mutual fund in each portfolio and equal weighting the three portfolios to create a “complete” portfolio. Purchases are determined by the one fund in each portfolio which has the highest trailing 6 month returns. The strategy rebalances each month, selling the current holding if it is no longer the top ranked fund in its portfolio and replacing it with the fund which has the highest momentum.

In other words, the complete portfolio equally weights the top one holding in the three portfolios outlined above. At most the complete portfolio will have three holdings – an equity, bond, and real asset. In some months, such as late 2008, VFISX has the highest 6 month trailing returns in all three portfolios; therefore, the complete portfolio could have less than three positions depending on market conditions.

You will notice a short-term treasury fund is in each portfolio. Absolute momentum simply means one of the mutual funds outperforms a risk-free asset class such as cash in addition to outperforming all of the other asset classes in the portfolio Thus, for the purposes of this test I added a short-term treasury fund to each portfolio to represent a risk-free asset and to act as a comparison point for absolute momentum.

The benchmark for the tests is the Vanguard 60-40 Balanced Fund (VBINX) which offers a better representation of  a complete portfolio when compared to a pure equity benchmark like SPY.  The strategy detailed above has offered strong historical returns at comparable volatility and much lower drawdowns compared to a balanced 60/40 mutual fund. Also note the Sharpe Ratio in excess of 1:

The results above since 2003 are impressive. However, before we announce to the world our discover of the holy grail, the strategy has under-performed a 60/40 investment over the past two years:

Recent under-performance offers us a lesson – strategies can work well for years and then struggle for months, years or never again. Prolonged periods of relatively low returns will test the patience of a strategy's followers.  Has the tide shifted for good on the strategy outlined above? Or going forward can we expect something similar to the results from 2003-2010?